In 2022 we witnessed financial markets around the world being disconcerted by the prospect of higher interest rates, as central banks attempted to contain rising levels of inflation. For 2023 there are a number of moving parts that shape my view, the most important of these being the outlook for inflation and how this will affect consumer demand. I remain of the view that inflation is a multi-year problem, but would not be surprised to see the headline rate fall in the first half of 2023. We may have already seen the peak in the headline rate in the US and would expect to see a peak in the UK and Europe in the next three months.
Last spring commodity prices, especially oil and natural gas, spiked higher as the war started in Ukraine and therefore, year on year, they are likely to be materially lower in spring 2023. That does not change the long term outlook for a sustained period of inflation running above the 2% target driven by wages, shelter, food, healthcare and travel cost rises; and the fact that central banks will be likely to continue raising interest rates until there is a clear trend back towards this target level.
It does however suggest that we might see a short term peak in the outlook for interest rises. This in turn will provide some relief to asset prices and stability to the lending markets, whether for residential property or at a corporate level. There are signs that rising interest rates are affecting economic activity, with growth slowing in many countries. But many companies appear reluctant to shed labour and if the labour market continues to be tight (due to geopolitics, demographics and deglobalisation) and wage growth accelerates further, there is the potential for further waves of inflation in the future. Against this background, companies may struggle to meet profit expectations if they do not improve productivity and this fall in economic activity could further reduce rate expectations at the same time.
You would typically not want to own commodities going into an economic downturn. They tend to be cyclical with a drop in economic activity leading to reduced demand and lower prices. I take a different view at this stage – supply in many hard commodity markets is reasonably constrained by many years of underinvestment. This particularly applies to oil, as some of the oil majors have progressively positioned themselves toward more sustainable energy investments in renewables, such as wind and solar, as they look to transition towards cleaner energy sources. The world’s transition away from fossil fuels will be slow and expensive and yet investment in the energy market has been low, driven by shareholder concerns and clean energy policy. An oil price of circa $80 a barrel when the world is entering a period of economic contraction would suggest, upon the resumption of expansion, the price will be materially higher. Furthermore, given China has abandoned the pursuit of zero COVID and has relaxed controversial restrictions on isolation requirements, testing and travel, commodity demand should increase rapidly next year, as well as providing some positive momentum for markets more widely.
The FTSE 250 has fallen materially this year (-17.8% in 2022) and yet contains many high quality businesses. Many of these have seen their valuations fall significantly and some of those companies with strong corporate balance sheets and low debt levels now look attractive for a long term investor. Whether it is the best quality engineering, retail, hospitality or house building companies, there is a growing case to take advantage of this weakness. The catalyst to start selectively adding some exposure could be the results reported from a very tough Christmas trading period, combined with a rise in unemployment in the next few months. We have seen some recent takeover activity in smaller and medium sized UK companies, which is reassuring and our criteria for the ‘shopping list’ is simple – high quality, low debt, robust supply chains and a sustainable competitive moat.
The political situation in the UK and Europe remains challenging and the environment ripe for populism. Political instability will remain a feature and is likely to stifle the legislative agendas of individual countries as well as the EU. This adds to the general caution towards Europe which is already suffering from uncertain energy supplies, rising rates and weakening demand in the face of any short-term resolution to the war in Eastern Europe. It is hard to articulate what a good outcome would be. An end to war is obviously positive but if it is driven by a peace deal between Russia and Ukraine, what is that worth? If we see Putin out of power, who replaces him and will they be any better? Are the Ukrainians reliable partners for the NATO powers or a future problem? As far as the market is concerned, the outlook is for a long, protracted conflict. I take that same view with low expectations for any improvement and the risk of further deterioration remains.
The US has many of the same economic problems as Europe but is insulated from some of the worst effects and is less reliant on external energy supplies, which makes it relatively attractive today. The UK’s problems are exacerbated by the sclerosis of the BREXIT effects, and whilst the US dollar has weakened recently, offering our latest government some relief, we are not convinced that sterling is any more attractive longer term. Overall caution prevails for the outlook for the UK economy. The US dollar and commodity currencies are likely safer havens, for the foreseeable future.
Another major issue for the world is the growing schism between East and West. The implications are manifold, but include a higher level of defence spending globally, the use of gold and other commodities for collateral, a shift in influence in the Middle East in favour of China, as biggest oil importer in the world, and a move away from globalisation to secure more robust supply chains, especially labour supply. Much of this is inflationary and suggests that the last decade of ever lower rates and limited inflation was a historical aberration. Deflationary headwinds over the last three decades have been primarily due to a surge in the world’s available labour supply, owing to favourable demographic trends and the entry of China and Eastern Europe into the global supply chain. Some of these demographic trends are reversing and it may be wise to invest accordingly, albeit with one eye on the structural growth of automation, healthcare consumption, technological innovation and cleaner energy usage. Given the ongoing geopolitical tensions with Taiwan and the continued deterioration of the US and China’s trading relationship, it remains sensible to treat the longer-term risks of investing in China with caution when weighing up the valuation opportunity in emerging markets.
Although the immediate outlook for the global economy looks gloomy, markets can rebound quickly as investors anticipate events, rather than waiting for perceptible changes in the real economy. Being invested in equities seems essential in the current economic environment. Moreover, it is possible that any recession could be relatively mild. Furthermore, ongoing labour shortages may actually encourage businesses to invest to boost productivity. There are several long-term investment themes that remain very promising as highlighted above, and longer-term, holdings in soundly financed companies with genuine pricing power still offer the best opportunity to protect and shield portfolios from inflation. It is these companies that should benefit most from the next phase of global growth, when it comes.
Charles Bathurst-Norman, Investment Director
The value of securities and their income can fall as well as rise. Past performance should not be seen as an indication of future results. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.