Commentary on April 2023
Global equity markets were broadly flat during April, with further gains in the UK (+3%) offset by a pullback in Asia and emerging markets (-3%). Overall indices have recovered from their sell-off in early March but have not yet been able to break out to higher levels. The regional banking crisis in the US continued to generate headlines, with First Republic Bank the latest to require a rescue package, however market fears about a broader contagion have waned. The logic is that the only banks that might fail are the ones that can safely be allowed to do so.
As tensions eased on one front, another problem unique to the US has emerged. The combination of a Democrat President and Republican-controlled Congress has led to a re-run of the 2011 and 2013 debt-ceiling political stand-offs. Talks to increase the limit on total government debt have reached an impasse, as Republican leaders seek to extract a promise of future spending cuts before they approve a higher ceiling. Back in opposition, the Republicans have rediscovered the virtues of fiscal rectitude. History suggests that after much political horse-trading, a deal will be inked at the last hour.
April also saw the start of the Q2 reporting season in the US. So far, the announcements have been slightly ahead of expectations, although still down for the second quarter in a row. Overall earnings are on track to decline 7.3% year-on-year, compared to a forecast of a decline of 8.1%.
On the economic front, the cycle is evolving slowly with no major surprises. The US economy is decelerating but continues to grow at a decent pace and inflation has continued to moderate, falling below 5% for the first time in two years. Employment is the ultimate lagging indicator and there are some early signs that is it finally starting to respond to the recent sharp rise in interest rates. Average monthly job creation slowed to 222,000 during the February-April period, from 338,000 for the previous six months, while wage growth has also cooled. The US Fed raised interest rates by a further 0.25% to a target range of 5.0% to 5.25%, and hinted that this might be the last for now in the most aggressive tightening campaign since the 1980’s. However, it also cautioned that there will not be any cuts if the rate of inflation remains too high.
The Bank of England is in a trickier position, with weaker growth and higher inflation. The UK economy grew slightly in the first quarter, rising 0.1% overall, but shrank by 0.3% in March. The central bank has backtracked from its previous forecast for a recession throughout 2023, instead it expects the economy to grow by 0.25%. However, it now also expects inflation to remain above target until 2025, falling to around 8% for Q2 and 5% by Q4. The stubborn pace of decline led to a further rise in the UK base rate of 0.25% to 4.5% – its 12th consecutive hike.
China’s economy grew at a faster pace than expected in the first quarter, as the country emerged from Covid Zero. GDP expanded 4.5% year-on-year, up from the 2.9% recorded in the fourth quarter of 2022, led by a rebound in consumer spending.
Over the past year, markets have been dominated by a central economic debate, as sentiment has swung back and forth between fears of higher inflation and interest rates and concern over the extent to which tighter policy might impact on growth and earnings. Markets (along with central banks) have consistently underestimated inflation and overestimated the speed at which it would fall. Things are at last slowly heading in the right direction. Inflationary pressure is coming down and the labour market is showing early signs of weakness. Policy tightening appears to be working.
Since the banking crisis, expectations for US rates have changed substantially. Markets are now pricing in three rate cuts before the end of the year, despite continued rhetoric from the US Fed that, while it is likely to pause here, it is not yet prepared to change course. In fact, it has continued to hike rates twice since the closure of Silicon Valley Bank first sparked the turmoil. There is therefore scope for disappointment if markets are forced to accept that rates will stay higher for longer. Equity markets are likely to remain rangebound until this is resolved.
In the meantime, our strategy has focussed on identifying cheap assets whose fortunes are less tied to the outcome of this debate. We have often commented on the relative value of the UK. Another market that stands out for similar reasons is Japan.
Markets move in very long-term cycles, and it is interesting to contrast the relative fortunes of Japan and the US in this respect. In 1989, Japan was the largest global market and accounted for 13 of the top 20 listed companies in the world by total size. In 2023 this list is dominated by 13 US companies, and not a single Japanese company remains. The index for Japanese equities has yet to recover its old high from 23 years ago. Stocks have been long out of favour yet have quietly been grinding out gains over the past few years, while markets in the West have faltered. Our Japanese positions on standard portfolios have received an additional boost from the decision to fully hedge the currency exposure to the yen.
A recent update from Warren Buffett has highlighted the potential for a relative change in the cycle back in favour of Japan. The Sage of Omagh believes that “the incredible period for the US economy is coming to an end” and foresees weaker profits across much of his domestic US equity portfolio going forward. In contrast he has continued to build exposure to Japan. The case is one of deep value that is gradually being realised as companies restructure, raise returns and buy back shares. On a macro basis, inflation has remained under control, interest rates are low, and the weaker yen has boosted the competitiveness of Japanese exporters. Moreover, there is ample scope for positive equity inflows. Foreign investors are heavily underweight Japanese equities (like the UK), while the large pool of domestic Japanese savings is also heavily underweight equities in favour of bonds. Only a small shift in the allocation of either of these assets would be very beneficial. Over the long term we believe that buying undervalued and under-owned assets in an uptrend is one of the best and safest strategies for returns. Japan, the UK and select emerging markets, along with gold and commodities currently fit this criteria.