Review: Q1 2023
The Relentless Unforeseen
By Martyn Page, Investment Director
STOCK markets got off to a good start in early 2023 due to optimism about the reopening of the Chinese economy following the surprise removal of covid lockdown restrictions. Happy New Year!
Energy prices continued to weaken, creating hope that inflation would fall more than previously expected and that interest rates might therefore not have to rise so high. Rightly or wrongly, this was seen as bringing forward the time when interest rate cuts might be back on the menu as a recession might be less likely.
But the main events of the first quarter were on nobody’s radar: the first banking run of the Twitter age in the US happened in the blink of an eye, followed worryingly closely by a comparable speedy withdrawal of large deposits from a Swiss investment bank, necessitating its rescue over a weekend and, at all costs, before markets reopened on a Monday. Conventional wisdom says that central banks keep raising interest rates until something breaks. In the first quarter, things started to break.
If you are looking for a silver lining then it is this: the weakness in the banking system will make our inflation problem less acute. Here’s how it works: Central banks raise interest rates at pace. In response, commercial banks’ assets (typically government bonds) fall in value. Some banks become more vulnerable to runs. All the other banks, whose assets have also fallen, quickly decide it’s time to be more cautious about lending. That means fewer mortgage loans. In turn, that reduces demand for housing. Since moving home is the single greatest trigger for consumer spending, this leads to a weaker economy. And that leads to lower inflation.
USA: Central banks in the EU, UK and US have all been forced into the most front-loaded, fastest-paced cycle of interest rate rises for decades. In early January, markets expected the all-important US central bank interest rate to peak at 5.0 -5.25 per cent. Recall that just one year earlier that rate had been essentially zero. This major tightening of interest rate policy over a short period, to squeeze inflation, is colloquially known as Operation Stable Door.
But perhaps in acknowledgment of the slightly more benign conditions, the US central bank raised its key rate by only 0.25 per cent at the start of February, having instigated a 0.5 per cent increase in December. This was then followed by a further 0.25 per cent increase at the start of March – albeit with the now inevitable indications of further tightening – taking the overall Fed funds rate.to 4.75 - 5.0 per cent. Unlike the UK, this is a set range of the lower and upper limits for overnight lending and acts as a guide for commercial banks to follow. Following the March increase, markets pencilled in a peak rate of 5.5 per cent - 5.75 per cent, 0.5 per cent more than anticipated in January. More interestingly, Wall Street analysts expect the Fed funds rate will be below three per cent by the end of 2024. This assumes that inflation will fall very rapidly over the next year.
UK: In late March, the Bank of England increased its interest rate by 0.25 per cent to 4.25 per cent and market expectations were for a peak at around 4.5 per cent this August, down from nearly 5.25 per cent expected back in November 2022. Meanwhile, the UK economy continues to flatline. The current government spins this as ‘avoiding recession’ but nobody is fooled. Recession is such a poorly defined word. If you keep your job, it’s a downturn. If you lose it and can’t find another, it’s a depression. The population is keenly aware that living standards will be slow to recover, but there’s an awful lot more to life than air fryers, electric cars and Dyson hairdryers.
The UK stock market is global in nature, does not mirror the domestic economy and is historically cheap – perhaps because it has been shunned by pension funds disinvesting in favour of liability-limiting bond portfolios.
Is the UK stock market then a giant car boot sale – an engaging mixture of rubbish and bargains? Listed property companies are deeply unloved and trade at wide discounts. Keep your eye open for news flow about acquisitions and takeovers as proof of value. Blackstone, the US private equity group, is to pay a 42 per cent premium for Industrials REIT which owns warehouses close to city centres where logistics space is scarce. Two years earlier it paid a comparable premium when it swooped on St Mowden, another commercial property company. And a Japanese conglomerate has just snapped up the delicious Franco Manca pizza chain paying a 35 per cent premium.
Europe: In the EU, the European Central Bank (ECB) belatedly continued to raise rates over the first quarter of the year. Although headline inflation is now falling, easing to 6.9 per cent in March, food inflation continues to soar - in Germany it is 20 per cent.
The ECB is perhaps the most political and least transparent of the major central banks. It was expected to raise rates yet again by half a percent in March. When faced with the unexpected demise of Credit Suisse, Switzerland’s second largest bank, the rate-hiking ECB faced unpalatable choices. A pause or mere quarter percent increase would have sent a message that the bank was worried. Since central banks are privy to more information than markets, this could have caused markets, already nervous, to panic.
With the Credit Suisse debacle following uncomfortably hot on the heels of the collapse of Silicon Valley Bank, it was clear that global credit conditions would be much tighter, thus doing some of the work of central banks for them. In this case, a half percent increase by the ECB might be overkill. Whereas common sense suggests ‘pause and assess’, the ECB went with the half percent increase, taking the deposit rate to 3.0 per cent. The external message was, indeed had to be, ‘we are concerned but not worried’. The internal message was more likely ‘let’s tough it out, we can always cut rates if we need to’.
The Basel Committee on Banking Supervision recognises that there are 30 systemically important banks in the world. These are giant banks whose risk profile is considered to be so important that a bank’s failure would trigger a wider financial crisis and threaten the global economy. Credit Suisse was one such bank. Think about that. In the space of a week, a globally systemic bank just disappeared, via a shotgun wedding with its larger rival UBS. This should be considered a success – it calmed markets at a critical time. Readers may take some comfort from knowing that while Credit Suisse had been a poorly run and ailing bank for years it emerged that UBS had already drawn up contingency plans for its acquisition. Sometimes you just get lucky.
Meanwhile, analysts currently expect the ECB’s deposit rate to peak at four per cent over the summer. At this level we can expect some impact on Europe’s economy. Rising interest rates will impact on banks with vulnerable balance sheets. Analysts have already started to pare back their estimates for company profits. That said, Europe remains home to many world-class companies who will gain market share at the expense of weaker rivals.
Outlook: Everyone wants an outlook statement. There are plenty of commentators prepared to pontificate quite precisely on, for example, whether, or not, there will be a recession, and, if so, whether it will be shallow or deep, and how that might affect shares and bonds. Markets are good at pricing in the known, but hopeless at discounting the unknown – they just don’t bother.
It is human nature to want to know what will happen in the future. That’s because life is relentlessly chaotic, and we find the chaos deeply disturbing. Yet, once written about, all unforeseen events rapidly become part of the narrative of news articles and financial reports. This makes everything that was unexpected (Brexit, Covid, Ukraine) appear in retrospect to have been inevitable. And then people run with the story.
That’s why we should periodically remind ourselves that it will be the relentless unforeseen that causes future shocks to markets. We who hold investments should remember this, so that when the next shock happens, we will not ask, as Queen Elizabeth II did about the global financial crisis, “Why did no one see it coming?”.
Martyn Page is the Investment Director of Worldwide Financial Planning which is authorised and regulated by the Financial Conduct Authority.
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