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Issue 65 - Looking For Green Shoots In All The Turmoil

I think this is probably one of the most difficult News & Views I have had to write, largely because there is so much going on, both globally and domestically, with what seems like unprecedented volumes of commentary coming from totally diverse sources – it is trickier than ever to work out where the truth lies through all the rhetoric!

I apologise therefore if this comes over as a rather “dry read” but I thought it appropriate to try to address current concerns.

As I think you already know, I see part of my role when expressing my views, is to peel back the curtain or to lift the bonnet, to see what is really going on behind the headlines and to find some central or what I would describe as sensible ground.

Where to begin?

I guess the UK is as good a place as any to start – in the last month, we have seen a new Monarch, a new PM, a mini-budget and the unfolding of the political party conference season, with plenty of sabre rattling and accusations, both within parties and on a cross-party basis.

Do Liz Truss and Kwasi Kwarteng know what they are doing? Listen to one side and “their way is the only way to see the UK economy grow”, whilst their opponents will argue the exact opposite. The truth is that only time will tell, and at the moment, there is no certainty that the mini budget will actually pass-through the process of acceptance/adoption in Parliament. I actually think, the strategy is a huge gamble from a political perspective because even if it proves successful in time, the upside is unlikely to be manifest in time for the next General Election, which has to be in January 2025 at the latest. I read an article the other day which looked at the financial strategies driven by John Major, which were unpopular but over time proved to be successful, but not in time to save him at the ballot box! Will history repeat itself; we will have to wait and see.

What we can be certain of, is that the mini budget added a huge amount of fuel in the UK, to the global fire of problems that was already raging and impacting the UK economy. This was seen most dramatically in the exchange rate, with GBP dropping to a record low against the US$ and in the cost of UK debt – (not mortgages but the rate at which the UK borrows) – this jumped to over 4% and was higher than the cost of Government borrowing for Greece.

I have extracted below, some parts of a piece written by James Penny, who is the Chief Investment Officer at TAM Asset Management, as I think he explains quite clearly how these aspects have impacted the UK.

What On Earth Just Happened?

For stock market geeks like me, yesterday will likely go down in history as a memorable moment in the UK, akin to that of a 2008 crash moment - one which people will be talking about for decades to come.

What happened? It has all spun off Kwasi Kwarteng’s “Mini Budget” which has proven akin to a fiscal hand grenade thrown into the UK bond market. UK Government bonds, under the triple threat of a massive increase in UK bond issuance to fund the energy price cap, further interest rate rises and quantitative tightening (that’s the Bank of England selling back all of the bonds they have been buying off the government for the past 13 years [started in 2009, I think]) the UK Government debt market has tanked quite spectacularly (hence the hand grenade reference). To put the selloff in perspective, in the history of the UK Government bond market, the largest single sell off was -9%. September’s sell off, as of Wednesday morning, from the highest point to the lowest, was down a touch over -30%. To call that a new record doesn’t quite do the situation justice and it’s chiefly why I have chosen to write a note explaining what’s going on.

As almost everyone knows, the backbone of the UK’s behemoth pension industry is UK government bonds and on Wednesday morning it looked like there were some very large pensions funds about to tip into insolvency from the losses being inflicted on portfolios. This is what prompted the BoE to intervene.

Shortly after the market opened on Wednesday the Bank of England got wind of the potential implosion in UK pensions and stepped in swiftly to prop up the market and essentially save a large number of UK pension savers. This came in the form of the central bank halting quantitative tightening (selling the bonds they have been buying for the last 13 years) and recommitting to buying £65 billion worth of UK government bonds at £5 billion a day for 13 days. Essentially the BoE turned from quantitative tightening into quantitative easing in a matter of minutes to save the UK pension industry. This had the desired effect. The mainstream UK bond market bounced up over 7% with long maturity bonds rallying over 18%. The positivity spread over into the US with government debt rallying over 1% and US stocks also rallying nearly 2% on the news. Great for investor portfolios.

The intervention we saw yesterday was welcome but doesn’t change our thinking when it comes to UK bonds and the UK economy. Economically it doesn’t make sense to be pumping money into the bond market at the same time as you are fighting inflation. They are opposing forces which will further clobber the pound and create unwelcome volatility - which will then need more aggressive interest rate hikes to tame. It’s a scenario which is simultaneously destroying the credibility of this government and of central bank at exactly the time as the UK population needs to be able to trust their leaders.

As with all scenarios before this and the many still to come, it’s worth remembering that it is darkest before the dawn and there will absolutely come a time for the UK to shine on both the bond and equity front and at this juncture TAM know what to invest into and in what size to capture the best value from the UK but we still see further uncertainty from here for UK inc.

James Penny
CIO, TAM Asset Management

Turning now to the value of GBP, exactly one month ago, the inter-bank exchange rate for GBP was £1 = US$1.147 and €1.157. Today the rates are £1 = US$1.137 and €1.152, so relatively small changes. In the intervening period however, we saw lows of £1 = US$ 1.03 and €1.10 at some trading points, which were dramatic falls over a short period, partly driven by the mini budget but also driven by market speculation and significant “betting against GBP”. The real story in my mind though, is that we are seeing a strengthening of the US Dollar against most other currencies worldwide and sooner or later, this trend will have to reverse as concerns grow about exports from the US, which to my mind, is the cyclical nature of markets at work.

One final comment about the UK, is in regard to the level of Government borrowing as I think there is some comfort when you look at the other G7 countries and the following chart demonstrates our relative position in relation to debt versus GDP.

That having been said, the numbers are still eye wateringly huge and will need to be controlled over the longer term.

Looking Further Afield!

The main problems for markets are still coming from a number of factors, the key ones in the headlines at the moment being the concerns over the war in Ukraine and whilst on the one hand, the successes being achieved by Ukraine are good to see, the concern is when Putin has his back to the wall, what will happen. Will he “lash out” or will he simply disappear perhaps!! (we can but hope!)

Inflation is probably the major global concern, which is of course being driven by supply shortages and escalating fuel costs and to combat this, we see increasing interest rates as the “traditional weapon” of the central banks. These are the things that are driving up mortgage rates, rather than the mini budget in the UK (which didn’t help but is not the main cause). I am not sure whether this “traditional” use of interest rate increases, is totally appropriate, after all, inflation is more typically driven by high demand rather than short supply. You could also argue that interest rates should have been increasing sooner, even before the inflationary pressures started to manifest, as rates had been held artificially and historically low for too long. That is another factor in why they are increasing so rapidly now as we are playing catch up!

But that is not the end of the story, because we need to think about what happens next?

A little research shows that the expectations are that global inflation will start to fall next year – one source, the US Federal Reserve Bank’s survey of Professional Forecasters suggests that the Consumer Price Index inflation will fall in 2023 to 3.2% and to 2.5% in 2024. This reflects other commentary I have read that suggest the back of inflation has already been broken and in due course, this will take the pressure off interest rates. Morningstar are predicting that interest rates in the US will fall back in 2023 as the inflationary pressures recede and as this trend unfolds, I would expect the UK will follow in time, but that path is less clear.

Even though UK inflation is expected to peak in October 2022, interest rate rises are likely to continue for some time before levelling off. So, analysts are then predicting a reduction in rates in 2023 and 2024.

The Impact On Investments and Investment Decisions

A frequent question and of course a major concern, is what does the near future hold and what investment decisions need to be considered now.

To my mind, there are three key factors to think about here:

• Objectives
• Timescales
• Attitude to Investment Risk/Capacity for loss

Arguably, these all overlap to a degree, because if, for example, your objective is to generate income over the longer term and your investments are structured in an appropriate risk profile for you, then the short-term capital values should be less of a concern. I fully understand that human nature says that none of us like to see reduced values, and instinct may suggest “we should run for cover” but over time, that has proven to be a bad decision in the longer term. The main reason being, that the same instinct will see you wait too long before re-entering the market and missing the best part of the upturn.

The same situation applies if you are investing for value preservation or growth; opting out at the wrong time will have a serious impact over the longer term.

As James Penny commented in his piece, when referring to the UK, specifically, there will absolutely come a time for the UK to shine on both the bond and equity front – I believe the same to be true when looking at the global position and as I have written previously, when markets do turn, they could well turn rapidly.

So What About Those Green Shoots?

Well, they are not there just yet, but I think that we will start to see them soon and with inflation peaking and interest rates slowing and even reversing next year, we will see those green shoots appearing and, in the meantime, try not to be overly influenced by the doomsayers!

As always, stay safe and our best wishes from all at Alexander Bates Campbell

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