November Monthly Note
Following recent market turmoil in the aftermath of the mini budget, Liz Truss has been forced out of Downing Street and Rishi Sunak, her Conservative party leadership rival only a couple of months ago, has now been chosen to replace her. Markets have reacted positively since new Chancellor Jeremy Hunt reversed almost all of the mini budget and signalled a new era of fiscal prudence and will take comfort from Rishi Sunak's rhetoric during the Conservative party leadership race that he will look to manage the public finances more prudently. He faces a tough job, however, given the broader economic backdrop and it remains to be seen whether he can steer the UK economy on firmer ground over the coming two years before the next general election.
It's earnings season in the US and so far, some of the biggest names in tech have disappointed, sending US tech shares tumbling. Microsoft, Meta (Facebook) and Apple all reported earnings declines, some quite substantial, and revealed plans to lay off more staff. The risk here is that headlines from some of the largest companies in America could well be replicated throughout the market, which remains to be seen.
In the last few weeks Russia has been frantically contacting foreign governments and explaining that it believes Ukrainian forces are preparing to use a dirty bomb to sway the conflict in their favour. Western governments deny this entirely and have stipulated that Russia may be using these allegations as a means to justify its own use of tactical nuclear weapons, or simply to deter further aid to Ukraine.
The macro backdrop for risk assets has shifted this year. Equities have come under pressure from higher inflation rates and recession fears as central banks have entered into a rate hiking cycle. Some value equities offer more protection against these threats compared with their growth peers, as they tend to benefit most from strong recoveries after recession and trade on lower earnings multiples. We are taking a more cautious approach to portfolio positioning for a possible recession. We still like selective growth stocks where there remains true innovation and potential for change, especially recent trends in consumer behaviour that were accelerated by the pandemic but prefer value equities on the whole. We have also lowered our overall equity weighting to neutral. Fixed income remains unattractive given record low (and negative) real yields and the thin spread between sovereigns and corporates offering little in the way of reward for risk. Bonds remain an important diversifier in our portfolios, but given current yields the return profile looks unappealing, with downside risk in long-dated government bonds remaining elevated given the outlook for interest rates and recent commentary from major investment banks regarding monetary tightening. Low duration bonds therefore look the more appealing investment, along with inflation-linked bonds which offer some protection to rising inflation. Duration will become appealing again as market participants shift their primary concern away from inflation and towards growth fears, however we are cautious in our positioning here. We also hold an allocation to cash to offset some of this fixed income risk. We have also been adding ‘alternative’ assets to the portfolios, which offer low-to-negative correlations to traditional asset classes (stocks and bonds) and give the potential to protect during times of significant market volatility, such as we are seeing at present.
We expect the UK to continue its outperformance in global equity markets. The UK market is very value-tilted and despite this year’s positive relative performance is still highly attractive on a valuations basis. The UK economy has also recovered well from the pandemic, though economic growth is faltering. The main driver of UK equity outperformance will be relative valuations.
There is good value to be found in European equities, however with war on the continent and the ECB lagging significantly in its inflation outlook and response, there are many headwinds on the horizon for European stocks. Many European equities are also vulnerable to rising interest rates, as debt levels are significant, and many will default if unable to restructure their payments. We remain underweight here for now.
The US represents poorer value relative to the rest of the world due to the high proportion of tech companies that still command a multiple far in excess of the broader market, however it also has the best long-term earnings growth and some of the most outstanding quality companies, as well as the most innovative. In times of global stress, the US also tends to act as a safe haven investment, which props up markets. We believe the US will remain an attractive investment option in the long-term, but with some obvious headwinds making us more cautious. President Biden has made no secret of his desire to increase tax rates, and the Federal Reserve have been clear they will not be getting any more accommodative.
We believe Japan to be an extremely poor environment for equity performance. The Japanese economy is predicted to grow at the slowest pace of all regions, in addition with a declining and ageing population, the prospect of future economic expansion looks unlikely. Thus, we expect poor relative equity performance from Japan. In the short-term, attractive valuations in the region may boost markets, but this will likely be short-lived.
Asia Pacific and Emerging Markets are predicted to see exceptionally strong GDP growth over the next year, but are struggling with the pandemic, particularly those countries who are not so able to distribute vaccinations to their populations. We remain concerned at the decreasing Chinese stimulus, together with regulatory crackdowns, investments in China require careful monitoring. However, the recent selloff in Chinese markets looks overdone given the longer-term outlook for the economy, and we remain positive on the emerging markets growth story in the long-term, and thus are comfortable maintaining an overweight position. The more recent remarks from the Chinese government have been positive but must be taken with a pinch of salt. We currently like frontier markets as a more attractive investment option within the emerging markets universe.