The eye of the most recent storm in UK investment markets appears to have passed but it would be premature to say it has cleared our shores completely. And then there is the question of the damage left behind and who pays for it? There is no shortage of commentators, all with differing opinions.
As investors we stick with facts. The global economy has been moving towards higher inflation, due to supply chain issues post Covid, since earlier this year. And expectations had been building that interest rates would have to rise, to dampen price pressures, with recession the result.
Widespread weakness in the global economy
Measured from the start of the year to mid-October (17th) the FTSE 100 was down 6.2%, the FTSE 250 down 26% (the latter contains more growth companies), the FTSE SmallCap index down 27% and the FTSE All share down 10%. In the US, the S&P was down 25% and Nasdaq down 32% (more growth companies). With such widespread weakness in stock markets, it is not surprising that the Investment Trust sector also fell, 23.5%.
The discount on investment trusts too has been widening, reflecting the negative sentiment besetting investors. The average sector discount has widened, from 2% at the start of 2022 to around 16% (mid-October). For some sectors in the Investment Company universe such as UK property and Private Equity, discounts have moved out to 40%.
Safe havens few and far between
Alternatives stretching from assets in renewable energy, such as solar and wind power, to specialist property sectors such as care homes, social housing and GP practices have all suffered from sharply widening discounts. Often the rents from the types of properties mentioned are index-linked, the occupancy levels in this sector are high and the ultimate guarantor of many of these assets is the government (as safe a guarantor as it gets). This wasn’t enough to shield them in an environment of rising interest rates and bond yields.
The prevailing poor overall sentiment around interest rates and the cost of servicing debt, especially where there might be gearing, is dominant. For energy companies, even those in the renewables sector, worries about a possible windfall tax is proving corrosive.
Where do investors turn?
There is a possibility that in the near-term the market may experience further volatility but on a medium-term horizon there is cause for optimism. However, for the market to turn around investors need to believe that both inflation and interest rates have peaked.
UK and US interest rates are expected to peak around the 5% level. With the UK base rate at 2.25% and the US benchmark rate at 3.0% to 3.25%, we still have a bit to go with rate rises. By Easter or maybe the 2nd quarter of next year, rates should have peaked. By then, economies will be in recession. How deep recession will be and what impact will be felt in company profits remains open.
When the pivot comes the rally will be swift
Markets usually look 12 months ahead and as soon as they detect that inflation and interest rates are turning, that may be enough to pave the way for a rally. Momentum in markets gets compressed quickly so when the pivot comes the rally will be swift. Mid to small-cap stocks in the UK, that have suffered disproportionately and offer very attractive value, should be among those rebounding most sharply.
In conclusion, we have a difficult six months ahead. Although unemployment is low, mortgage rates are going up and consumers’ wealth and expenditure is under pressure. It is difficult being a UK investor at present but overlook the politics, concentrate on company fundamentals and the market will be for turning … just not quite yet.
