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There’s plenty for investors to mull over as we move into the final quarter of 2023.
Inflation worldwide has, in recent months, started to head downwards after a two-year period of rising and stubbornly high prices. Meanwhile, global economic activity has remained reasonably resilient despite a considerable and prolonged period of monetary tightening – in the form of raised interest rates – from central banks.
Growth, however, is starting to slow, and fears of recession have begun to rise. What’s more, with interest rates looking set to remain higher for longer and the Israel-Gaza conflict liable to have an impact on oil prices, there’s plenty to occupy investors’ thoughts about how best to position their portfolios to the end of the year and beyond.
We’ve put together a panel of experts to answer the investment questions of the moment: Antony Webb (AW), deputy head of managed portfolio services at Quilter Cheviot; Stephen Payne (SP), portfolio manager, global equity income team, Janus Henderson; Preeti Rathi (PR), senior investment director at Investec Wealth & Investment (UK); and Kasim Zafar (KZ), chief investment officer at EQ Investors; Sanjay Rijhsinghani (SR), chief investment officer, LGT Wealth Management.
What’s surprised you most about the stock market this year?
AW: The resilience of consumer demand and the resulting strength in corporate earnings, despite interest rates rising at a very fast rate. You would traditionally expect households to tighten the purse strings as mortgage rates go up and credit availability shrinks. Generally speaking, however, consumers have been buoyed by higher wages and excess savings accrued during lockdown. Economic consensus is that rising rates impact inflation and the economy with a one to two-year time lag, so perhaps corporate earnings forecasts will start to reflect that in the new year.
SP: The resilience of growth-oriented companies in the face of rising real interest rates.
PR: The strength of US technology stocks in the face of rising real interest rates. The speculative boom in artificial intelligence (AI) could be behind this, as could the relentless flow of money into global and US index funds. But growth expectations baked into the tech sector appear to be on the optimistic side.
KZ: It has surprised us how resilient the market has been despite a slowing down in earnings growth. We see equally compelling reasons for the market’s resilience to continue, but also the impact of higher interest rates to start biting and to be reflected in further corporate earnings weakness.
SR: The outperformance of passive equity strategies versus active strategies this year has been surprising. While we know that a handful of mega tech AI-related stocks took the US S&P 500 higher, it is surprising to see passives outperforming active management at a time when stock selection is paramount and during a cycle involving the hiking of interest rates.
What’s the biggest risk to investments over the next 12 months?
AW: In autumn 2022, inflation was the number one risk, with concerns over spiralling inflation driving interest rates higher, which impacted on both bond and equity prices. UK, US, and European base rates are now around 5% and inflation is slowing. Consumer demand, company earnings, and employment have proven resilient despite rising rates, while excess savings accrued during the pandemic are being depleted. If interest rates stay at current levels for a sustained period, consumer demand will weaken, company earnings will fall, and unemployment will rise. Central banks may be aiming for a ‘soft-landing’, but history provides very few examples of rate-rise cycles that didn’t ultimately end in recession.
SP: Just when everybody thinks it is safe to go back into the water, a US hard economic landing hits. A soft, or even, no landing now seems to be the consensus, but such misplaced optimism is typical just before a recession takes place. The long and variable lags of monetary policy are about to bite after the most aggressive series of interest rate hikes in decades.
PR: That inflation refuses to fall and that central banks have to keep rates high or even raise them further. This would put more pressure on public and private sector finances as well as depressing financial asset valuations. Even if economies slowed, central banks might not be willing to cut rates. Such ‘stagflation’ would be the worst possible outcome that we see. It’s not the likeliest scenario, but could happen.
KZ: With the market having rallied over 20% from the lows of October 2022 and with earnings growth slowing, one of the biggest risks to equities comes from expensive valuations. Valuations face further headwinds as the market is slowing – coming around to central banks’ rhetoric that interest rates need to be maintained at higher levels for longer to bring inflation back down to target levels.
SR: Apart from geopolitical events, we perceive a high oil/energy price to be a big risk. We have always viewed a high oil price to be a ‘nasty’ tax on both businesses and households. In the current climate, high oil prices may complicate the job of central banks, as we could see it feed through to the core inflationary numbers.
Where will the FTSE 100 end the year?
AW: We envisage a scenario where the FTSE 100 climbs to around 7,700. We are unlikely to see any significant revisions to earnings from global companies by the year-end, so any move in FTSE 100 valuation is likely to be driven by exchange rates and the relative value of international earnings. When sterling falls, share prices of large, international companies tend to rise as the value of their overseas earnings increases. For the FTSE 100, 75% of earnings come from outside the UK.
SP: Around 7,700, in other words, broadly where we are currently. The top 10 Footsie companies account for 50% of the index and they all benefit from dollar exposure. This means the recent swan dive in sterling [which has seen the pound weaken against the dollar] leaves them pregnant with upgrades into the year-end. Higher oil prices help, too. This offsets a weaker underlying earnings trend for the fourth quarter.
PR: Exactly where it is now. My money would be on the fact that the market will keep worrying about ‘higher for longer’ interest rates and a potential US government shutdown over the next month or so, before we hit the ‘Santa Rally’, a common occurrence in December when share prices rally as the year-end comes into view. Looking at current returns, the FTSE 100’s performance is flat year-to-date and that’s a big contributor to our preference to diversify globally.
KZ: The FTSE 100’s sector composition makes it an interesting market as it has both defensive and cyclical elements, while the companies in the index gain most of their revenue from outside the UK, so it offers a useful barometer for global growth conditions. On the defensive side, about 30% of the index comprises consumer staples and healthcare companies. These sectors are usually more defensive in weak environments. Meanwhile, about a quarter of the index is exposed to cyclical sectors like energy and materials that benefit from higher commodity prices. This balance between cyclical and defensive explains why the median analyst forecast for the index by the end of the year is to be approximately unchanged.
SR: It’s difficult to say exactly where it will be. But if the pound continues to weaken and we see continued strength in oil and commodities, then there is every reason to believe it may outperform other developed market indices.
Which sector/region will perform well over the next 12 months?
AW: The UK fixed income market looks primed to perform well. We appear to be close to the end of the rate-hiking cycle and the action to date has resulted in a decent level of yield on government debt of around 5%. Prices will fluctuate on uncertainty, but we don’t see yields going significantly higher from here. Taking a mixture of both sovereign (for example, UK gilts and US treasuries) and investment grade corporate debt gives investors a good opportunity to capture high yields during a period of equity market uncertainty.
SP: Recent revisions highlight that the UK economy has performed much better than originally thought since coming out of Covid. The UK equity market is extraordinarily cheap with a lot of bad news already priced in. An event like a recession would be the clearing event that sparks the rally.
PR: Emerging markets offer the perfect scenario for success: a weakening US dollar, fantastic demographics to fuel growth and a broad reliance on China. We have seen data recently suggesting the attempts by the Chinese authorities to stimulate their own domestic economy are finally having an effect and we believe this has a direct spill-over effect into the wider emerging markets region. Inflation in China remains close to zero implying there is also ample space for further monetary stimulus if needed. From a valuation perspective, looking at both earnings and dividend-based models, emerging markets appear to be below fair value adding to the appeal.
KZ: Although all regions face similar headwinds, we think Japanese equities have several positive drivers now. Relative to other regions, Japan has much easier monetary policy. This is getting more restrictive, but it’s still substantially more accommodating than other developed markets. In addition, long-touted governance reforms are gradually being implemented, with the single biggest outcome being a greater focus on shareholder returns by Japanese boardrooms. With its heavy industrial & IT sector bias, the Japanese equity market is a cyclical one that should also benefit from any growth in corporate capital expenditure, driven mainly by industrial automation.
SR: Based on recent geo-political events in the Middle East, along with the oil production cuts we have seen by Saudi Arabia and Russia, we could see oil, energy and commodity sectors perform strongly over the next 12 months or so.
Name a stock or a fund that investors should think about buying
AW: In our equity allocations, we favour high quality companies that can continue to thrive regardless of the economic backdrop. For that reason, we like Microsoft. It is our largest single equity holding in our US exposure. The company has a strong product suite and consistent earnings as the incumbent tech provider for a large number of businesses and households. The recent artificial intelligence theme has helped the share price this year, but we see this primarily as an example of the company’s adaptive ability to pick up multiple threads of opportunity within the technology sector, future-proofing the business from disruption while evolving its core software offering.
PR: Estée Lauder would be my top stock pick for a long-term investor. The company has had a sharp pull-back this year to date, declining by over 40% in value in sterling terms due to issues in its travel retail business. However, its longer-term track record of value creation speaks for itself. It has heavy exposure to China and travel retail, both of which are now showing strong signs of recovery. Estée Lauder also has a strong brand portfolio and geographic profile with names such as La Mer, Jo Malone London, Clinique, and Tom Ford beauty to name a few.
KZ: The Sanlam Global Artificial Intelligence fund is my current top pick. We have been following manager Chris Ford since 2018 and have been invested with him since 2020. The AI theme has recently come into the mainstream, but we think we’re still in the early stages of what this technology will ultimately be capable of helping us achieve. Importantly, the theme spans across all industrial sectors, from IT to healthcare, to e-commerce and financials.