Well, it has certainly been another eventful few months. Given everything 2022 has thrown at us, perhaps it should come as no surprise that Collins has chosen “permacrisis” as their word of the year!
The last update was sent out on the day of the ‘mini-budget’ in September. Unsurprisingly, the international investment community did not take well to a budget of potentially unlimited borrowing, with no clear plan on reducing debt in the future and no independent assessment by the OBR (Office of Budget Responsibility). Government borrowing costs (gilt yields) soared, the pound plummeted, the UK stockmarket fell and there was criticism from around the world. The Bank of England had to step in to support gilt prices to prevent a meltdown in defined benefit pension schemes and the mortgage market stalled with lenders pulling mortgage products in fear of steeply rising interest rates.
Subsequent weeks saw a reversal of the most contentious policies before Chancellor Kwasi Kwarteng was sacked after just five weeks in the job. After appointing Jeremy Hunt as Chancellor, who proceeded to roll-back even more policies, Liz Truss was finally ousted (sorry, resigned) after an eventful and record short time as Prime Minister; just 44 days. After a brief internal ballot, Rishi Sunak was then installed as PM, the fourth conservative PM in the last six years who has not been voted in by a general election.
Whilst Sunak and Hunt have rolled-back virtually all of the mini-budget policies and restored a semblance of calm, the damage done to the UK has been significant, in terms of our reputation for prudent fiscal management and the impact on the UKs finances. At one point the movements in government bond and currency markets were likened to an ‘emerging market’ and one investor highlighted the risk of investing in the UK as the “moron risk premium”. The impact on the reputation of the conservative party has also been significant which raises the potential for a change in government in the next general election.
The subsequent Autumn Budget was a clear sop to international markets and an attempt to re-establish the government’s fiscal credentials. To some extent this worked as gilt yields, the pound and the UK market have now recovered to levels before the mini-budget. Unfortunately, for the UK people, this means higher taxes, a further squeeze on public services and higher interest rates; the Bank of England raised rates by 0.75% to 3% and markets expect rates to rise to nearly 5% next year. Both the Bank of England and the OBR have forecast a shallow but potentially long recession in the UK; GDP fell by -0.2% in the third quarter and any fall in the fourth quarter would confirm a technical recession.
Outside of the UK, the US mid-term elections provided a surprise for Trump and the Republican party as the expected ‘red wave’ failed to materialise. The Democrats retained control of the senate but lost control of the house, which is fairly normal in mid-terms but does create a legislative battle ground for the next two years of Biden’s term as President. Trump’s candidate’s poor showing in the elections has raised the prospect of a battle with Florida Governor Ron DeSantis for the republican nomination for president in 2024. Recent protests in China by citizens fed up with harsh lockdowns seems to have resulted in a significant reversal to authorities ‘zero-covid’ approach. This has been taken well by markets as it should be beneficial for global supply issues and hence inflation.
Markets
Given the events of the last few months, markets have generally been quite resilient, with major stock markets up around 5%, in local currency terms, since September. The UK stock market is actually now higher than it was before the mini-budget, which is something of an enigma given the undoubtedly worse conditions we now face. Interestingly, on the days when the Bank of England and OBR forecast a recession and also reported negative GDP, the market barely moved. This could mean that markets are already pricing in a recession to some degree.
The most recent market rally (since early October) is most likely due to expectations on inflation and interest rates which has been the driving factor for most of this year and will likely continue to be a key issue into next year. A very small fall in the US inflation rate (8.2%-8%) resulted in one of the largest single-day rises in markets all year; the S&P500 index jumped by +5.5%! The optimism was based on the idea that easing inflation would reduce the need for central banks to keep raising interest rates.
Economists are expecting a peak in inflation by the end of 2022 or early in 2023. Assuming the inflation trend then remains on a downward trajectory, interest rates should peak soon after. However, while current high rates might decline, we should get used to higher average rates of inflation and interest rates than we have been used to over the last decade; a return, perhaps, to the more normal, healthier even, pre-credit crunch conditions.
The cost-of-living increases plus higher mortgage rates will unquestionably affect consumers spending power and this could lead to lower corporate profits in some sectors. However, in aggregate, corporate and consumer balance sheets remain healthy which allows them more flexibility to ride out difficult times. Combined with low unemployment, this means the recession could be relatively shallow rather than the large downturns of the late 80s and early 90s.
Whilst all this feeds through the system, volatility is likely to remain elevated and there could well be a further dip in markets in the new year. However, it is always worth remembering that equities (shares) are a ‘real’ asset; they give you a share in the profits of a business that has the potential to increase prices and maintain or even grow profits after inflation. Strong companies that can last through a downturn will come out in a stronger position, with less competitors and the ability to capitalise on the economic upturn. Market volatility, per se, is not a risk; it’s an opportunity to benefit from better prices in the pursuit of attractive long-term ‘real’ returns.