At the start of the year, we thought the dominating focus for financial markets would be inflation and the economic reopening of China following the lifting of coronavirus restrictions – but as Benjamin Disraeli, who twice served as the UK’s Prime Minister, once said: “what we anticipate seldom occurs; but what we least expect generally happens.”
Although very little has changed in our outlook since the start of the year, financial markets have been extremely volatile. There has been a constant procession of speculative themes and events: inflation, disinflation, sticky inflation, economic growth, recession, interest rate increases and interest rate cuts, to list but a few!
However, the most nail-biting event during the valuation period (5 January 2023 – 5 April 2023) was the collapse of Silicon Valley Bank (SVB) in the US and the rescue of Credit Suisse by its Swiss rival UBS, which brought back all that anxiety and fear we experienced during the 2008/9 global financial crisis.
The reaction by financial markets has been enough to give any roller-coaster ride a run for its money. In fact, we have felt more like Sisyphus during this valuation period as we have seen portfolio values rise nicely, only to see them fall back down, and then rise and fall again, as financial markets looked for a definitive direction.
Thankfully, unlike Sisyphus, portfolio values won’t be consigned to an eternity of unending frustration because the US central bank (the Fed) is close to ending (if it hasn’t already finished) its most aggressive tightening cycle in decades as inflation is cooling rapidly.
In fact, as a short, mild recession currently appears inevitable (especially as credit conditions have tightened since the collapse of SVB), we believe there is a good chance that interest rates will be cut before the year is out. As the US is the world’s largest economy, this policy change will not only be an important signal to other central banks around the globe, but more importantly it will be very supportive for both equities and bonds.
Income Element
As we have written many times, in being too aggressive in increasing interest rates, central bank policymakers run the risk of becoming Milton Friedman’s ‘the fool-in-the-shower’ (where a person gets burnt by hot water after they turn the hot water all the way up, given the shower water initially came through cold). Unfortunately, this came home to roost during the valuation period: by increasing interest rates so much in such a short period of time, they clearly didn’t consider the impact of their previous increases and that caused several banks to collapse.
This has additional implications as banks are now likely to further tighten their lending requirements in the short term as they will want to build up their liquidity – and less lending will further slow the global economy, making a mild recession inevitable.
This suggests to us that peak interest rates are actually a lot closer than policymakers are currently suggesting, which means that yields will undoubtedly drop and prices (which move inversely to the yield), will rise.
As such, our strategy of holding a diversified spread of secure companies with investment-grade credit ratings and stable income until their maturity continues to look sensible.
Long-Term Growth Element
Equity markets always tend to overreact to uncertainty and economic events as they assume the worst, only to recover those losses when cooler heads prevail and the worst-case scenario doesn’t materialise.
Whilst we fully appreciate and understand that these periods of equity market volatility are unpleasant and unnerving, investing is about the ‘time in’ rather than ‘timing’ the market (i.e. it is best to invest with a long-term time horizon and ignore short-term trading noise and excitement).
This difficult, but important, lesson was reinforced again during the valuation period as the collapse of SVB led to a selling frenzy in equity markets, which was quickly reversed as it became obvious that it was much ado about nothing as SVB wasn’t a systemic risk to the financial system and hence the sell-off had been overdone.
However, a welcome by-product of this trouble in the banking sector is that banks are likely to tighten their lending requirements and thus do much of the work central banks’ aim to do in tightening monetary conditions.
As a consequence, we believe it is probable that we will see interest rates start to be cut before the year is out – and this prospect should strengthen global equity markets, barring any elevation of geopolitical risks.
Equity portfolios remain well diversified and constructed to capture long-term opportunities. For example, we continue to like the US region as lower interest rates should boost technology stocks which dominate by weighting the US stock market.
Portfolios are also overweight in Asia and Emerging Markets (which means they have a higher weighting than the benchmark). In addition to the region’s good long-term growth story (positive demographics and a growing middle-class population), China’s economic reopening will reignite consumption and economic activity, which is especially positive to the wider Asian region.
Investment Management Team