- Greater cyclical volatility in share markets
- Liquidity has steadily been withdrawn from markets
- The UK’s perceived risk premium has reduced
The FTSE 100 has performed well through 2022, at least by comparison to many other prominent national benchmarks. Unfortunately, that is at odds with domestic economic performance, as the spectre of stagflation looms over the UK economy. But any near- to medium-term difficulties should not distract us from the realisation that capital markets are reverting to the conditions under which they operated for much of the second half of the 20th century.
It may seem that investors are snookered on several fronts as we enter 2023, not least because the negative correlation between bonds and equities has become less evident as we move further away from an unprecedented era of accommodative monetary policy. We might also reasonably expect greater cyclical volatility in share markets, which acts as a disincentive to invest in high-growth, high-risk businesses that soak up capital. The discount rate applied to future earnings could become more unpredictable, while the cost of capital will also be a more critical consideration than it has been for some time. Throw in the general fall-away in market liquidity and it’s apparent that investors will need to be more proactive and flexible in their tactical allocations.
Turning Japanese?
Although it seems probable that the inflation rate will moderate by the end of next year, the UK is facing a prolonged period of sluggish (or negative) growth. Comparisons have already been made with Japan’s experience following the collapse of the nation’s asset price bubble in late 1991. The problems besetting Japan in the 20 years following the collapse were more complex than those faced by the UK, but they resulted in a slump in both productivity and real wages over a lengthy period. It took until 2012 before the Nikkei 225 index sprang back into life, but performance has been lamentable compared with other major national indices. However, commentators believe that it could be one of the best performing indices next year, as Japan is at a different stage of its economic cycle and GDP could continue to grow above its long-term trend rate.
It’s not possible to forecast economic developments with certainty, let alone the movement of indices. The best we can ever do is to weigh up what we are hoping to achieve as investors against the balance of probabilities. As things stand, the UK is the only country in the G7 where output has not yet regained its pre-pandemic levels and is likely to remain in recession until summer 2023, according to the new EY Item Club autumn forecast.
The economy is not the stock market
Yet for investors there’s no reason to put on a tin hat and hide under the bed. Although there is an undoubted relationship, it is unwise to conflate the stock market with the economy – that said, viewing either in isolation is not to be recommended, either. Through 2022, for example, we have seen a continued rotation out of growth stocks, but this has as much to do with their sensitivity to interest rates, rather than decisions based on fundamental analysis. And in many instances, market participants are ahead of the curve where the economy is concerned; seeming disparities between the health of equities markets and the overall economy often come down to timing.
So, although next year promises to be every bit as unsettling as 2022 on the economic front, it’s worth remembering that share markets tend to recover well in advance of the economy in general. History also shows that index valuations retrace over time before heading off towards new highs. It’s not a linear progression, but it’s the jagged nature of the recovery that provides opportunities for anyone in search of price anomalies, or at least those willing to stomach some near-term volatility – grist to the mill for value investors.
Naturally, investment goals change over time, along with an investor’s risk appetite. This is the overarching consideration where independent financial advisers are concerned. Unfortunately, the market is no more accommodating to them than it is to anyone else. Against that somewhat doleful realisation, the fact is that market volatility benefits contrarian strategies, even as it highlights the importance of sound fundamental analysis.
Market liquidity and index-linked sell-offs
Market valuations have been in retreat as liquidity has steadily been withdrawn from markets. But it’s worth remembering that a given stock isn’t cheap because its share price has fallen; it’s simply that it is cheaper than it was. It could just as easily signal that a period of market over-exuberance has ended. There are usually good reasons why a company’s shares have been offloaded, but anomalous pricing is a fact of life despite what advocates of the efficient market hypothesis would have us believe.
The separate reality is that many quality stocks with defensible market positions, solid balance sheets, and strong cash generation have been marked down due to selling by professional money managers. To a significant degree, share prices for index constituents are in lockstep with index movements. However, the influence of private investors, at least in terms of price discovery, cannot be ignored – a point made clear during the initial market volatility brought about by the pandemic.
Inflation and the unvirtuous circle
Again, on the balance of probabilities, it would be reasonable to assume that inflationary pressures will be in evidence throughout 2023, even though economic growth will be subdued. The worrying state of the world economy has triggered demand for the safe-haven US dollar though 2022, raising the translation cost of commodities, while forcing central banks to further tighten monetary policy – a vicious cycle, or a kind of unvirtuous circle if you will.
The danger exists that inflation will still be a feature of low-growth economies due to the trend towards deglobalisation or, more accurately, the truncation of supply chains. On top of this, net-zero policies and the apparent determination of the European Union to constrict agricultural yields will feed into supply-side pressures. In a nutshell: inflation may peak sooner rather than later, but market interventions by national governments and transnational bodies will continue to stimulate upward pressure on prices, thereby ensuring that we will have to contend with negative real interest rates for longer than we might have hoped.
Darkening jobs outlook and inverted yield curves
One of the more improbable aspects of this year’s economic downturn is that until recently it has been accompanied by a buoyant jobs market, a hangover from the pandemic that contributed to wage cost inflation. But employers are now signalling a negative outlook on job creation, a point borne out by the Office for Budget Responsibility, which has forecast more than half a million job losses – although even this would equate to a still relatively low unemployment rate of 4.9 per cent. A deteriorating labour market will help to dampen economic activity, although cost-push inflation will still be evident in the energy and agricultural sectors even if the conflict in Ukraine is finally resolved.
The grim outlook is reflected in the growing number of countries with inverted yield curves, a situation in which shorter-term government bonds have higher yields than long-maturity debt. The inversion is often taken a harbinger of recession, although it is seen by some as merely correlative, rather than causal. It may even be that the relatively small sample size renders any correlation statistically insignificant. After all, data from the Office for National Statistics show that since 1955 the UK has experienced eight economic shocks when gross domestic product fell between two and five consecutive quarters.
At any rate, the UK’s perceived risk premium has reduced since Rishi Sunak took office, reflected by the consequent dip in gilt yields from their most recent peak towards the end of September. At the time of writing, 10-year gilts were 197 basis points adrift of their two-year counterparts and closing. As bond yields equate to the opportunity cost of investing in equities, any reduction in the former is generally favourable for the latter.
Could the FTSE 250 retrace to its average annual return?
Where are we now? Even with the benefit of record cash returns, the expected total return for the FTSE 100 has been pitched at around 4 per cent this year, admittedly not a far cry from the risk-free rate, but a clear premium, nonetheless.
The expected outcome for the more domestically focused FTSE 250 is a little more prosaic given that it has dropped in value by 19 per cent since the start of the year. It should be remembered that the index has delivered an average annual return of 6.3 per cent between March 2005 and September 2022. And there are some less than inspiring economic assumptions baked into its current valuation. That spells ‘opportunity’ for anyone willing to separate the wheat from the chaff, although investors would be in for a bumpy rise ahead of any sustained recovery.
As we approach the end of 2022, the FTSE 100 index is essentially flatlining in the year-to-date, whereas the Germany's DAX 40 and France's CAC 30 are down 10.3 and 7.3 per cent, respectively. Meanwhile, the tech-focused Nasdaq has shed 30 per cent of its value over the same period, a reflection of the sell-off of some of the most heavily weighted stocks in the index. The FTSE 100 is an outward-looking index, so it is undoubtedly influenced by macroeconomic trends, although it derived little benefit from the run-up in tech stocks in recent times due to the ‘old-world’ composition of the index. This point, along with persistently elevated energy prices, partly explains why the needle has hardly budged in 2022.
Back to the future in 2023
Leaving aside the relative performance of indices, the main point to take on board is that we, as investors, are operating in a wholly different market environment than we have experienced through much of the 21st century. We will not only have to be a little nimbler in terms of our tactical allocations, but fundamental analysis will play a greater role in deliberations as growth stocks will no longer find support from the distorting effects of excess market liquidity. In broad terms, it is likely that we will witness further pressure on equity valuations through 2023. But the main point to keep in mind is that the investment landscape has been profoundly altered by central bank policy over the past year or so – yet, in a sense, we are back where we were when we exited the dotcom boom.
