- 6th January 2023
- Posted by: Celticfp
- Category: Investment Committee
“Welcome to 2023” said the note on the restaurant door. The door was shut, the lights were off, and another note explained that rail strikes meant staff and customers were unable to get there. All the venues in this City-of-London street were closed in a scene reminiscent of the height of the 2020 lockdown. Life can be tough in the battle for a fair share of the economy’s revenue flow, and we cannot have been the only ones left feeling that the UK is off to one of the most subdued starts to a new year we can remember.
Yet, this week, the UK’s main stock market – as represented by the FTSE 100 – achieved its best price level since April last year, surpassing the 17 January 2020 pre-Covid level of 7674.6. This leaves it less than 3% below the all-time high of 7877.5 reached on 22 May 2018. In total return terms (with gross dividends reinvested) the index is now at its highest ever, with an absolute return of 15.4% since that peak of May 2018.
It is not quite the same for UK plc as represented by the mid-cap stocks of the FTSE 250. They have shown a positive but small return, a total of 2.7% for the same period.
Those businesses represented in the FTSE 250 are more UK-centric than the FTSE 100 constituents, although one should not overstate it. The charts below show the indices’ geographical make-up:
The period of UK mid-cap underperformance is more closely aligned with the commencement of interest rate rises. One thinks of smaller firms being sought by investors for their earnings growth-orientation, but this comes with relatively higher financial gearing while revenues are more volatile. It means they can become stressed more quickly when rates rise and demand falls. This appears to have been anticipated by investors over the past 12 months.
Perhaps there is some light at the end of the rate tunnel. While year-on-year inflation data will continue to be uncomfortably elevated, the now more persistent decline in European energy costs is also happening here in the UK, and that will take some pressure off the Bank of England. Indeed, the UK’s central bank may now be amongst the most dovish of developed world central banks, given that the Bank of Japan tightened policy just before the holidays.
With less valuation pressure from rising rate dynamics, more revenue positivity would be a great help for stocks in 2023. There may be good news on that front as well, given global consumer demand could recover sooner than previously thought.
To this end, European stock markets have had a great start to the year because energy prices have come down quite sharply, partly because of a bout of warmer weather. More importantly, Russia may be looking for a way out of its great mistake. Gas prices have continued to decline, particularly in the longer-dated contracts.
And now there is no doubt that China is exiting from its mistaken policy of trying to hide away from the virus. We write below about the sudden changes (so sudden that even at this late hour, there are announcements being made about helping construction companies). China’s stock markets have bounced in a way reminiscent of the 2020 bounce in western markets, when an end to lockdowns appeared in sight, and there seems to be little to hold them back. Of course, the danger is that pressures on China’s healthcare system engender a reversal of the opening up, but the levels of vaccination in the younger population are very high – as good as anywhere in the world. Even though there are likely to be many tragic deaths among the elderly, the awful fact is that there is now no way back from the path the Chinese leadership have embarked upon.
That should stoke global demand, providing a much-welcomed offset to slowing dynamism in western economies. Amongst those, the US is not slowing dramatically and is not likely to do so anytime soon. Today’s employment data showed a continuation of steady job gains and no compensating increase in the labour supply. Thus ,the unemployment rate fell back from 3.6% to 3.5%. We have written before that the US Federal Reserve (Fed) is by now more focused on labour market tightness than outright price rises – for fear of second–round effects embedding inflation structurally in the economy. Not surprising then, that many Fed members have been talking this week, with almost all saying they see rates heading above 5% and staying there. The market is having a hard time agreeing with this view, seeing the likelihood that rates will not go above 5% and will start falling before the year is out.
This has led to the first consumer-focused high-profile bankruptcy in this rate cycle. This week, Bed Bath & Beyond, famous in the US for providing beds, baths and other big-ticket items, announced it was pulling the plug (so to speak). It got caught with high leverage levels and failed to secure financing. Interestingly, it did not fail because of a lack of potential demand. Rather, it was unable to get the financing to buy inventory, which then meant its customers went elsewhere.
The Fed knows that this situation will be repeated for similar companies, but there is little it can do about it – the purgatory effect of the late cycle environment at work. Despite the headlines of layoffs coming from the likes of Amazon, there are too many firms that have been waiting to pick up workers. That will not include the mid cap companies with weak balance sheets, though. They are now the subjects for the phrase ‘the squeezed middle’. For us, this typical ‘late-cycle’ phase puts a premium on stock and credit selection, which was already the key determinant of outperformance during 2022.
Interestingly, these companies may well be few and far between, and credit market dynamics appear to be in better shape at the start of the year. However, this is one for us to watch closely over the coming weeks for signs of any broadening into a more systemic issue. For now, they have actually improved this week, despite Bed Bath & Beyond’s demise. Credit spreads declined somewhat, helped by the rapidly improving situation in China. That provides a window of opportunity for many companies to issue bonds over the next few weeks, and may help bring about a more relaxed start to the year than we saw in 2022.
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This article is for information purposes only – should not be perceived as financial advice. We recommend you should always speak to a financial adviser before making any investment decisions.
Please note, past performance is not a reliable indicator to future returns. Your investment may fall as well as rise, and you may not get back what you put in.