Market update - welcome to the twilight zone
Our recent acquisition of Punter Southall Wealth has brought many benefits – not least the arrival of Thomas Becket, their highly respected Chief Investment Officer. Here Tom shares his views on investment prospects and challenges during the current ‘twilight zone’.
Like many of my peers, I was lured into the wealth management industry on the promise of excitement and the prospect of “long, peaceful summers in financial markets”. The good news is that the first suggestion was correct; it is a privilege to manage our clients’ assets, work in such a fascinating industry and invest in ever-changing markets.
However, the final statement is total fantasy; my last relaxing summer was in 2006. Of course, three young children have added to my stress levels, but the last 15 summers have thrown up banking crashes (2007-9), European debt crises (2011-2015), commodity stress (2014), China concerns (2015), Brexit (2016), interest rate worries (2018), COVID-19 (2020-21) and a combination of most of those factors so far in 2022! It’s enough to put you off ever investing again.
However, it’s worth recalling that asset markets have made healthy progress over the last 15 years and, despite the challenges ahead, history suggests that further progress will be made in the future.
Cloudy with a chance of turbulence
Despite our long-term expectations for positive investment returns, which have strengthened after the turbulent start to 2022, it is fair to say that the immediate outlook for a range of global macroeconomic, market and corporate factors is particularly cloudy. This is not a case of us trying to express extreme caution but rather an admission that it is impossible to have certainty in a time when “the only certainty is uncertainty”.
Adding to this unpredictable environment is the inescapable fact that we have never really been here before. The COVID-19 pandemic, the government response and the various stimulus measures of the last few years have ensured that previous historical episodes are at best imperfect and mostly pointless guides.
I have always believed that a wealth manager’s role is to take the most extreme negative and positive outcomes (which are always fashionable in our industry) on a range of key factors and weigh up a sensible balance of probabilities. This helps us to shape our asset allocations and allows us to invest with conviction in specific investments and themes. Today we will discuss those key factors, explain our ‘base case’ for each and show what that means for our investment strategy.
Key factor 1 – the global economy
The economic outlook is clearly the most important factor influencing investment decisions. In periods of economic strength, investment portfolios typically make positive returns. The weakness in asset markets this year reflects the fact that expectations for the economy have broadly deteriorated through the year so far, impacted severely by the conflict in Ukraine, while fears of a recession have risen. It is too early to say whether we will endure a mild recession or a severe slowdown from previously healthy rates of economic growth, when the global economy climbed out of the COVID-19 crisis and pent-up demand fuelled positive economic momentum.
Our view is that recession and slowdown are purely technical terms; what is important is the fact that economic growth has basically stalled, and we are not concerned about a terrible economic outcome at this time. This view means that we are looking for investments that are either priced to allow for an excessively negative outcome or can deliver growth in an uncertain environment.
Key factor 2 – inflation
To evaluate the prospects of economic growth, we must try to forecast what will happen to inflation, as this is currently the preeminent driver of consumer spending and corporate confidence. There is good news and bad news.
On the negative side, we are yet to go through the worst of the inflationary crisis in the UK; the Bank of England is forecasting that inflation will possibly hit 13% later this year, with the key impulse behind this eye-watering level being energy and gas prices. Undoubtedly there are other factors behind the inflationary surge, but assuming this influence doesn’t persist into 2023, the good(ish) news is that inflation should moderate next year.
While the UK’s cost of living crisis is worse than that being experienced in most places around the world, the general trend of moderating inflation should be observed across the globe. Most importantly, we are starting to see evidence of this in the US economy, where gasoline prices have begun to reduce the inflationary problem. However, the unanswerable questions at this time are how fast will inflation fall and what level will it sink to? This is the key focus of our attention in the coming months – and should we reach a point where we believe the inflationary tiger has been tamed, we will be confident in taking higher levels of risk in discretionary portfolios.
Key factor 3 – interest rates
Our obsession with inflation will be shared within the hallowed halls of the global central banks. Over the last few years they have demonstrated a miserable mix of utter impotence and major miscalculation in their views on inflation, as they protested that the price surges were merely transitory. They also failed to recognise the damage that their stimulative efforts had wrought when mixed with government giveaways during the pandemic and discombobulated global supply chains.
They are now playing a dangerous game of catch-up, with the largest rate increases seen for decades in the major developed economies. Despite their perceived standing as masters of the financial universe, in reality the central bankers have no special insight into what may happen next, and there is a real danger that they will go too far at a time when the economy is in danger of a massive slowdown.
This concern contributes to both the twilight zone scenario we have already painted, and a trenchant desire not to take too much risk until we have greater clarity on the ultimate destination of interest rates. We believe asset markets have become too blasé in the last two months about the potential risks of significantly higher rates in the period ahead. This view also means we are sceptical about holding too great an exposure to assets with significant interest rate risk, such as government bonds.
Key factor 4 – corporate earnings
Another key contributor behind the forlorn hope of those promised sleepy summers is the fact that the financial world never stops, with companies reporting their earnings and updates for the second quarter of every year in July and August. This quarter’s earnings season has been particularly important, and is being viewed by investors as pivotal. Would companies be able to overcome the economic deterioration in recent months and still grow their profits? Perhaps more importantly, what confidence did they have for the months ahead?
The recent results have been a veritable mixed bag, but companies have defied the gloomiest of expectations and are relatively sanguine about their prospects. This has been a mighty spur behind the recent recovery in global asset prices and, in our view, propelled equity markets from an oversold situation at the end of June to a more neutral footing now.
Our own reading of the reported results was that they were undoubtedly satisfactory, although flattered by the rampant gains in energy companies’ earnings. However, they are not necessarily an efficient guide to future earnings potential. Moreover, while they were enough to encourage a recovery in prices in the last few weeks, they were not strong enough to justify an increase in risk in our strategy or warrant the extreme valuations seen in certain sectors at the end of last year.
Key factor 5 – market valuations and investor positioning
The two crucial observations within financial markets since the end of last year are the step change in the valuations of certain asset markets, most notably corporate bonds, and a reduction in the unbridled optimism that investors had at the end of 2021. Both factors were encouraged by the seemingly endless support that central bankers offered investors, which has been temporarily stopped and reversed.
When we try to think about the future return potential of key asset classes, we must blend a short-term view with more important structural calculations. Given the impediments to constructing a concrete short-term view, we are relying more on what we think might happen over the medium term, probably best defined as one to three years out from today. Equities, at a broad level, look to us to be about the right price as we look forward a few years, but for active managers there are plenty of dependable sectors worthy of our focus, and certain other themes and markets that are good value, in our opinion.
Government bond yields have risen, affording investors a modicum more income, but remain relatively unattractive and have become very volatile, leading us to a continued underweight stance. We will continue to discuss at what point our view on the asset class might change.
We are much more enthused over other fixed income markets and there are certain investments across global corporate bond and credit markets that have been unfairly treated by investors this year, amplifying unnecessarily the prospects of economic weakness and corporate defaults. While we are not being ‘gung-ho’, we are working hard to research specific investment opportunities with recovery potential, that offer high levels of income and where we are comfortable taking risk. The good news is that there are a reassuringly high number of such investments to help us justify our optimism about discretionary portfolios’ medium-term returns.
Conclusions and investment strategy
It would be inexcusable for us as investment strategists to throw our hands up and declare that it is too hard to make forecasts about the future, even if we are operating in a twilight zone scenario. We believe that the recent market volatility is here to stay for the coming months, and it is not appropriate to be taking excessive levels of risk in our investment strategies.
While we are expecting inflation to moderate next year, the incline of the descent is far from certain, and it is impossible to predict what the central banks might do next. Our hope is that inflationary pressures subside rapidly, and central bankers do not have to push interest rates too much higher, although this is frankly unknowable at this time. This lack of clarity justifies our balanced stance on equities.
Finally, the greatest confidence we can glean in this uncertain world is by investing in attractive assets at sensible valuations, hopefully benefitting from long-run trends that can survive this summer and flourish in many summers to come. George Gershwin was wrong about “Summertime, when the living is easy”, but this year’s challenges have not dulled our excitement about the outlook for investing in the future.
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Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.
This is not a recommendation to invest or disinvest in any of the themes or sectors mentioned. They are included for illustrative purposes only.
The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.
The information contained herein is based on materials and sources that we believe to be reliable, however, Canaccord Genuity Wealth Management makes no representation or warranty, either expressed or implied, in relation to the accuracy, completeness or reliability of the information contained herein. All opinions and estimates included in this document are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information contained herein
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Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.
Investment involves risk and is not suitable for everyone.