SK Investment Insight – June 2023

“You may not control all of the events that may happen to you but you can decide not to be reduced by them.” Maya Angelou.

We, like you, are conscious that the investment markets have entered another period of turbulence – there has been little respite from the daily dose of financial uncertainty over the last few years.

But investing is for the long term. It requires patience and while we will take a closer look at the markets below, we want to encourage you to do three things:

  • Reduce the time you spend looking at your investments.
  • Review (and if needs be replenish) your cash reserves. Having an emergency fund is important at times like this.
  • Review your household budgets and cash flow forecast. This should help to provide you with the confidence (or not) that you will not run out of money, based on current economic data.

It’s all part of having a financial plan, the key is not to leave it too late to plan.

Current Market Conditions:

We are aware that some of you are concerned about the recent reduction in your valuations. In conjunction with our investment partner, Square Mile, we take a look at current market conditions.

Let’s start at the beginning – what’s been going on?

In just a few short months at the start of 2023, we saw the FTSE 100 breach the 8,000 level for the first time, followed by what has been dubbed a ‘mini-banking crisis’, with the collapse of Silicon Valley Bank and New York Signature Bank in the US, as well as the acquisition of Credit Suisse by UBS.

Bond and stock markets served up a rollercoaster ride during this time, but closed in positive territory. Failures and shotgun weddings in the banking sector stole the headlines in March and there are likely to be further casualties due to the abrupt withdrawal of the punchbowl of ultra-cheap liquidity from which governments, companies and investors have been binging for more than a decade. 

The banking sector as a whole, though, is much more robust than it was before the 2008 financial crisis – now 15 years ago. The outlook for bond markets looks finely balanced as the tug-of-war between inflation and economic growth continues. Investors in bonds are at least now being paid a reasonable rate of return just to own them. In equity markets, companies most at risk are those which will need to refinance high levels of debt. In contrast, companies with dominant market positions are best placed not only to raise prices at least in line with inflation but also to weather any economic downturn.

What’s going to happen with interest rates?

The months of interest rate rises have been a constant source of conversation and headlines as the Bank of England grapples to steady and reduce inflation.

The direction of interest rates continues to be a central preoccupation for fixed income managers – as it is for all of us. The expectations of those we spoke to over the past three months fall into three broad camps. 

First, there are those who feel the current tightening cycle is drawing to a close and rates should start to decline, citing an imminent recession and easing inflation. These have therefore started to increase their exposure to longer duration issues. Others take a contrary view, believing inflation continues to be problematic and interest rates will remain higher to counter this, and so are keeping interest rate risk tempered.

A third set of managers are sitting on the fence somewhat, stating there are simply too many unknowns to make a major bet on rates. This cohort prefers to remain neutral on duration and endeavours to outperform the benchmark through other means such as bottom-up relative value investment strategies ie stock selection or curve trade positions.

Our feeling is that inflation is likely to settle at a higher rate to what we have become accustomed to, which means central banks will hold off cutting interest rates in the near term. If this is the case, this will lead some managers to be cautious about their exposure to risk assets such as equities and within fixed income, high yield and emerging market debt.

What will the fallout be for companies and credit?

Despite their mix of views on interest rates, managers were almost unanimous in their outlook for credit, believing company defaults will rise from the ultra-low levels experienced over the last decade. This will of course have an impact on investment opportunities as managers try to avoid companies at risk of defaulting.

That said, the expectation is that default rates are likely to remain within a relatively subdued 3% to 5% range. This is low by historical standards but still represents a significant increase on where they currently stand.

This is due to a combination of factors. The withdrawal of cheap debt in an environment of higher interest rates will punish overly leveraged companies. At the same time, companies struggling to absorb supply chain inflationary pressures, or pass them onto their customers, will see their profit margins tighten, which in turn impacts their ability to service debt.

Is high inflation here to stay?

While inflation is easing, it is likely to settle at a higher level than recent historic averages. In an environment where higher inflation is the norm, those asset managers who have greater flexibility within their mandates have allocated to more resilient asset classes such as infrastructure and real estate, although valuations in these areas of the market are starting to look less appealing. 

That said, the yield spikes from fixed income witnessed over the last year means the returns available from these asset classes are more attractive than they have been for some time.

Is there a recession coming?

Recent market volatility means that, even among global managers who emphasise bottom-up stock selection, it has been impossible to ignore the macro backdrop.

Many now see a global recession as likely towards the end of 2023, or early 2024 and their thoughts are turning to weathering a prolonged downturn. This means a refocus on valuations, particularly at a regional level, with managers switching interest from the US to Europe and Japan, and a preference for quality companies with strong pricing power, with the caveat there are limits to the level of price inflation their customers can absorb.

Nonetheless, there remains a cohort with a thematic, longer-term approach who continue to see the current backdrop simply as short-term noise. These managers are happy to maintain their positions unless there is a fundamental change in their conviction in the investment case supporting them.