Market commentary: 1 July 2023 – 30 September 2023

There will again be a day when equity and debt markets are not driven by the actions of central banks, but fifteen years after the global financial crisis we have yet to experience one (excepting the COVID crisis). The third quarter of 2023 saw a continuation of familiar narratives: inflation remains significantly above both the stated target level (2%) and central bank expectations. Their approach to the consequences of their own actions (keeping interest rates at zero for twelve years and then firehosing the economy with debt) is reminiscent of Homer Simpson’s plaintive cry in The Simpsons Movie “Why does everything I whip, leave me?”.  

Since November 2021, the Bank of England has been playing catch up; raising interest rates at every meeting. Until now. Two weeks ago, the BoE maintained interest rates at 5.25% in the expectation that inflation will return to target by Q2 2025. This is possible but unlikely in the face of sustained and immobile underlying inflation. The headlines concerning rising oil or food prices are a distraction from the underlying cause of the persistence of relatively high inflation – service prices and wage inflation. Wage inflation is high because inflation is high: it is a feedback loop. History (Volker, 1980’s) has shown that inflation can be tamed, but that this is a painful process with many negative consequences. Recessions are usually required to diminish wage inflation (and to lead inflation down). The BoE’s reluctance to raise interest rates further should not be construed as indicative of success in quelling inflation, it is a damage limitation exercise. The damage they seek to avoid is the economic pain caused by interest rates that people and businesses have become unaccustomed to. The consequence of the failure of central banks to take their medicine is that the patient doesn’t recover. The actions of central banks to stop tightening the brakes means that the peak interest rate is likely to be lower than forecast, but that the current higher rates are likely to persist longer as inflation will not have been cured.   

Our base case is that recession is probably inevitable though it is fair to say that the US and UK have shown surprising resilience in the face of difficult economic headwinds. However, those headwinds remain and may increase as the higher cost of debt percolates through the economy. While the US may escape a deep recession, the chances of Europe achieving this is significantly lower because Europe has structurally lower growth. The share of government spending as a % of GDP is around 55% across Europe – the UK is slightly lower at 53%. In the US it is 43%. High tax and spending can lead to economic stagnation. After the Thatcher reforms the average UK and US citizen had broadly similar earnings and wealth. The average US citizen is now 1/3rd wealthier than her European counterpart and this gap is widening. Part of our reason to recently rebalance long term asset allocations towards the US is with this in mind. US$ performance versus sterling and the euro in the coming years may also be positive. (Source: Bloomberg).

In addition to this, Europe is experiencing the suffocating impact of “net zero” targets. The inevitably higher energy costs associated with “renewables” lead directly to deindustrialisation. Energy intensive industries will be driven to countries that are not forcing the price of energy higher; China the obvious beneficiary.  

Property is the “sentinel” asset when it comes to rising interest rates; it is like the canary in the mine. Investment and commercial property valuations and returns are driven by the immediate cost and availability of debt. Residential property prices provide a lagged return as many have fixed mortgage rates that gradually run off. It is an understatement to say that investment property markets are currently challenging. They are, from many accounts, worse than during the global financial crisis because, while asset prices were crushed during the early days of the crisis, the collapse in interest rates saved the day. There may well be a painful readjustment of property prices over the coming months and years as the sticky higher interest rates continue. We reduced our property asset allocation to zero in Q1 2023.

Equity markets have been absorbing this mostly negative news and have been able to make some progress – the S&P 500 is up 15% over the last twelve months and the FTSE100 is up 8% over the same period, but markets have been directionless and range bound. It should also be noted that these numbers are pre-inflation.

We remain defensively positioned with high levels of cash and a rigid focus on high quality, short duration debt assets (principally 6 month UK gilts which are currently producing an annualised risk free 5.4% return). Our equity focus is value driven and we are actively avoiding the highest valued US equities. We retain a portion of assets in gold and it is in this “alternatives” space that we see greater opportunity to make money for our clients in the coming months.