Q3 2023 Market Review

We approached Q3 with optimism. Not because we expected this quarter itself to be stellar, but because valuations on any medium to long term basis are as good as they have been at any time in the last 15 years. That said, markets need confidence, specifically with respect to inflation and economic growth. The question was whether they would get that in Q3 or not?

Starting with inflation, in our view there is now broad-based disinflation (slowing inflation rates) across a large range of economies. The UK has been a laggard in this respect all year, despite making significant progress in the last 3 months, with the annual rate falling from 8.7% in June to 6.7% in September. To give you a better approximation, if you add up all the monthly inflation data points we’ve had in 2023 so far, you get to a rate of 3.2% for the year to the end of August. Depending on what happens in the last quarter, it is highly likely UK inflation will end 2023 between 4% and 5%, so this certainly eases the pressure to take interest rates higher.

As a result, policymakers around the world, including the Bank of England, have now signalled their willingness to pause interest rate increases and watch the economic data points from here to see the effect of their decisions. It’s worth remembering that before their September decision to hold rates at 5.25%, they had voted to increase them 14 times in the last 14 meetings. The important point for us is that with interest rates now as high as they have been at any point in the last 25 years, there is now significant downward pressure on inflation.

25 years – US Federal Reserve Interest Rate

The other pressing issue is whether economic data would start to signal a slowdown or recession in Q3. Cooling but not cold would be a good characterisation. Again, looking at the UK, house prices are now down around 4.5% over 12 months, and overall GDP growth is running at just 0.6%. Many expected worse though. In the US, data has been mixed, though more resilient.  Importantly, in both locations the jobs market remains very healthy, with high employment and slowing (but still high) wage growth.

If Q3 represented the picture we would see for the next 12 months, it would be one of slowing inflation and resilient growth, which is an ideal investment environment. Unfortunately, markets haven’t quite bought into that yet, and continue to be worried about both an inflation resurgence and a ‘hard landing’ (recession), which traded off against the good data and has meant markets have fluctuated through the period, though largely ended where they started.

To highlight specific markets, the FTSE 100 has been the bright spot, up 2.19% on the quarter, largely due to a big increase in oil prices which helps the likes of BP and Shell. US equities on the other hand struggled, and the European index lost 4%.

With respect to bonds, there was definitely a stabilisation in yields here in the UK. Gilts still produced a marginally negative return, but UK corporate bonds did better as interest rate expectations were reigned in slightly, adding 1-2% in 3 months. US treasuries on the other hand had their worst quarter of the year so far, as yields move out in response to stronger than expected economic data.

In summary, we saw significant economic progress in the direction we had expected. Inflation continues to slow, interest rates look to have all-but peaked, and economic data is slowing but not dire. Market confidence is still lacking, which is understandable after such an extreme 18 months.

For the sake of clarity, the ‘yield’ on an investment is the ‘income’ it distributes. If capital values fall, the yield increases. If the yield looks attractive then the capital value should rise, reducing the yield. There is a natural trade off here, in that your capital value is the price the asset is worth today. The value of that capital asset is essentially derived from what is within the portfolio. If you own secure assets driving an average 6% yield (income), then our view is that this will prove highly desirable when interest rates and inflation fall. Therefore, the capital value will rise. To benefit from the rise in capital value however we have to sell the asset. If we are to sell the asset, we have to have something more compelling to buy. Hopefully you can see the challenge and the opportunity.

Portfolio Review

It’s now around 12 months since the “income” into our portfolios significantly increased. To recap, in the world of low interest rates that we had become very accustomed to after the financial crisis, portfolio income, just like cash interest, was very low. Pretty much all of your return was driven by prices going up (capital growth). Now it’s different, with income very much back, and portfolio yields between 4% and 7% depending on the risk profile selected.

Income returns drip into portfolios across the year, as they accumulate bit by bit every day, and when capital values are volatile, it’s hard to see the benefits. Over longer periods things start to become much more visible, and we are now close to a year from where we were able to add significant income yields into our portfolios as markets sold off in response to Liz Truss’s tax plans at the end of September last year. This provides us with a 12-month time frame from which to review the benefit of receiving a full year’s income into our numbers.

Now it’s also worth saying this period hasn’t exactly been plain sailing. Economies were supposed to slow much more speedily into 2023, the consumer has remained far more robust than mainstream estimations. In the UK, wage rises went a long way to support the consumer, as well as increased savings courtesy of the limitations on spending imposed by the Covid years.  At the start of the year markets expected inflation to be 2% by now, so economists globally have had to rethink matters. Essentially, the gameplan is unfolding, though progress has been slower than we had thought. The positive from this however, is that as the chart below highlights, our income yield in October last year in our Low-Risk portfolio was 5.4%. Since then, capital values have continued to fall, though our yield has compensated for this and provided a positive return over the period. At the same time however, our yield on the same portfolio has risen to over 6% to the end of September 23. This provides excellent forward insurance if markets continue to lose value, though equally once capital markets stabilise, this should provide a very strong basis for forward growth.

Another key factor to our return outcome has been the relative performance of our equity picks, which in the majority of cases have performed well ahead of their respective markets over the same period. This has naturally affected the higher risk portfolios to a greater degree, with the income comparatively higher lower down the risk scale.

Combined together, although the absolute numbers are still not delivering the potential we expect, we have delivered very well versus our peer versus benchmarks, with an average differential of 2.89% over 12 months. And it’s not just the results which are positive, but also validation of the concept that we don’t need strong market growth for returns to be good from here. Don’t get me wrong, we still need to do a good job, and selecting the right equity and bond opportunities is a significant challenge, though that income underpin is going to make a consistent difference to returns come what may.

Market Outlook

There are broadly three scenarios that could play out over the coming 12-18 months, all of which have different short term investment outcomes, though over the medium term will lead to similar results.

The first, a “hard landing”, is where the tightening in policy that we’ve seen over the last few years causes a recession in 2024. The recession is a result of the rising costs of mortgages, restricting the consumer and the businesses that have been surviving due to low interest rates, start to default on debt repayments and the unemployment rate rises as the economy slows. In this environment inflation would be squashed and interest rates would be cut faster than currently expected. Lower risk portfolios with large allocations to bonds would perform well, but equities would struggle, effecting the higher risk portfolios.

The second, is where economies slow but not enough to cause a recession. This “soft landing” would be enough for inflation to keep trending lower, but without the bad economic implications. This would be a great environment for equities and bonds, with all portfolios performing well.

The third potential outcome is a “no landing”, which is where instead of slowing, economies remain resilient. With the jobs market already tight, wage growth would continue to be high, keeping interest rates higher for longer. Inflation would remain under control though rates could be kept at more meaningful levels, as the economies would be able to support the extra costs of sustainably higher costs for borrowing. This would be bad for equities and bonds in the short term, as interest rates go above 6%, and portfolio yields have to rise once again. Markets have fluctuated all year with all three of these outcomes, and at present we feel the greater probability sits somewhere between one and two as the most likely path. This would be positive in the short and medium term for our portfolios. In the third scenario, a ‘no landing’ isn’t a bad medium-term outcome, in the short term we would have a continuation of falling capital values, albeit with increasing income, so materially the longer-term sustainability for portfolios is good, though positive total returns take longer to materialise.

Where does that leave us then? Well like always, there are a number of ways things could play out from here. The consistent (constant) thing we have in our favour is the income. This will either protect us against capital falls or enhance returns if we have capital growth. Either way it’s a good thing. It will absolutely drive strong investment returns over 3-5 years in all our scenarios.

The short term as always is hard to predict, and we appreciate that investment markets have remained frustratingly inconsistent. We are frustrated as a committee; however, the markets are what the markets are.  However, we now have a significant amount of income to protect from sell offs, and over the next 12 months, (unlike the last 12 months), we are highly unlikely to see a continuation of monthly interest rate hikes. We expect interest rates to be priced towards their peak, to stay flat before reducing. In that scenario we remain very bullish about our forward return forecasts, and we genuinely have not seen valuations like we have at present since 2008 coming out of the global financial crisis. We would be delighted if we can emulate the performance achieved in the 5 years that followed.