A compass for choppy waters

My last two columns (‘Darkest before the dawn?’, 21 April 2023 and ‘Tilting towards the storm’, 12 May 2023) suggest investment trust discounts have widened to very attractive levels and, more generally, market sentiment is overly poor relative to outlook. This is a good entry point for long-term investors.

Market volatility is set to continue for a variety of reasons and such a journey and pivot, no matter how measured, is rarely a smooth one. Our compass in these choppy waters remains firmly fixed on UK equities and private equity companies given their attractive valuations and prospects.

Making progress

Last month’s column set out in some detail the challenges facing the market. More volatile and ‘stickier’ inflation than central banks are forecasting, higher interest and discount rates, and elevated ‘growth’ valuations after a long period of outperformance, have helped to create a challenging market environment. Other geo-political and economic factors including the hardening of strategic alliances and continuing high debt levels have contributed. In addition, such factors have also helped to usher in a new market regime which will favour ‘value’ over ‘growth’ as an investment style for the reasons set out in the column ‘The ending of an era’ (23 September 2022). The market has much to countenance.

In increasing the portfolios’ equity exposure in recent months these challenges are not underestimated. The fact global policymakers have been behind the curve when it comes to controlling inflation and their continuing poor record of forecasting is one such challenge. This will remain a source of volatility for markets. It is crucial for central banks to get a grip in both senses because such errors are adversely affecting the real economy and peoples’ lives as households struggle through a cost-of-living crisis. Inflation and the level of interest rates affect everything from mortgage rates to business loans, from wage negotiations to spending plans. Yet the omens are not good.

Recent testimony by the Bank of England to the Treasury Select Committee highlights the extent to which inflation modelling needs updating. While no one can predict Black Swans, claims that unexpected shocks such as the invasion of Ukraine accounted in large part for the leap in inflation which took central banks by surprise simply ignores reality. In the period leading up to the invasion, inflation rose steeply. Money supply figures were high and clear signs of inflation were evident in the economy. A month before the invasion, inflation stood at 6.1%, and yet interest rates remained at 0.5% – woefully inadequate if the Bank was serious about its remit of keeping inflation under control, and preferably below 2%.

There is strong evidence to suggest QE went on for too long and this helped to stoke inflation. The first round restored bank balance sheets, but the second reached the real economy. The bank denies this. But, as Professor Tim Congdon and James Ferguson highlight, how does the MPC explain that China, Japan, Switzerland and others who faced the same supply shocks but, because they had not inflated the money supply, saw virtually no inflation? Quantitative Tightening (QT) will prove just as problematical. At least the bank last month finally increased its short-term inflation forecast from 3.9% to 5.1% – a big increase. The OBR is sticking to its forecast of 2.9% for now, but reality will also dawn.

Market volatility is also reflecting other geo-political and economic concerns. The nuances that used to facilitate diplomacy are fading and strategic alliances more generally are hardening following the invasion of Ukraine. One manifestation is that key countries and trading blocs are focusing on the importance of key supply chains being ‘onshored’ or at least relocated. This is more likely to be inflationary than not, but also has wider connotations. Key commodities and AI are proving to be further pieces on the chessboard. The Atlantic Declaration gives testimony to the importance major nations are attributing to such developments.

Meanwhile, the high levels of debt within the global eco-system, despite the extent to which double-digit inflation has eroded nominal values, restrict policymakers’ response to events for fear of creating further economic turbulence. The recent drama in Washington about the debt ceiling again gives testimony to a wider problem. High debt also acts as a deadweight when it comes to growth with high taxation being the poor substitute to ensure elevated government spending can continue. Such factors help account for market sentiment being very negative. However, these factors are largely known – they are part of the equation. History suggests it is at such times, when markets are fearful, that investors should buy.

The valuations of certain sectors reflect this poor sentiment more than others and therefore perhaps represent the better opportunities. The UK market presently stands at an historically wide discount relative to peers at a time when the new investment landscape should provide at least a modest tailwind given its composition. The private equity sector also looks very attractive given the extent of the discounts to be found and the expertise and track record of managements. The discounts are more than compensating for expectations that NAVs will come under pressure given the wider economic scenario – expectations which underestimate the managers’ cautious valuations, as seen when investments are realised.

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