Commentary on November 2023
FESTIVE GREETINGS FROM CHARLWOOD’S
The traditional Santa rally came early this year, as financial markets staged a strong recovery from their October lows. Global equities surged 4%; there have only been 11 stronger months for the world index since 1969. A series of slower economic data allowed traders to become more and more convinced that central banks have finished their aggressive campaign of interest rate hikes. A US government shutdown was also averted, as President Biden signed a stopgap bill to circumvent the current political stalemate and extend funding into early 2024. US stocks chalked up their largest monthly rise for three years, rising 5%, although gains were more moderate elsewhere, with the UK up 2.2%. The initial move was led by large cap growth and technology stocks. However, attention soon switched to oversold cyclical sectors that would benefit most from an economic recovery spurred by lower rates. Small caps surged 7%. Talk of rate cuts also produced a big rally in bonds, which rose 3% on average. US 10-year bond yields, having briefly risen above 5% in the middle of October, retreated back below 4.5%. In the UK, 10-year bond yields fell to 4.1%. Gold finally broke through its previous all-time high, touching a record $2,138.
The driving force behind these gains has been a dramatic sea change in the outlook for interest rates following a series of better-than-expected inflation data across major economies. October’s CPI print for the US was unchanged for the month, reducing the odds of another interest rate hike close to zero. While the Fed didn’t make any formal policy changes at its November meeting, the Powell press conference was widely seen as having a more dovish tone. Inflation also slowed sharply in the Eurozone, with the CPI falling to 2.4% year-on-year. The narrative received a further boost when the UK joined the party with a third slower-than-expected inflation reading. Consumer prices rose 4.6% from a year earlier in October, down sharply from 6.7% a month earlier and the slowest pace since 2021. Prime Minister Sunak was happy to take credit for the fall, although it was mostly driven by a sharp drop in the energy price cap resulting from the global decline in energy prices. Elsewhere, China slipped back into deflation, with a fall in the CPI of 0.2% over the previous year.
A number of metrics indicated that the US economy is finally slowing down following the Federal Reserve’s long campaign to rein in inflation. Gains in employment were lower: non-farm payroll printed at 150k in October, well below the 180k expected by the market and less than half September’s print. The unemployment rate increased to 3.9% from a recent low of 3.4%. The Beige Book activity index slipped into negative territory for the first time since the start of the pandemic, suggesting a pullback in consumer spending. However, this was not borne out by strong initial figures for the Black Friday shopping season, which saw sales rising 7% over last year.
In the UK, no growth continued to be good news. The economy flatlined once again in the third quarter, defying forecasts of a small contraction and ensuring a recession is avoided for the time being. Consumer confidence headed higher in October. House prices also rose for the second month running, up 0.2% according to data from the Nationwide.
If further proof is required that UK equities are cheap, three more listed companies became the target of takeover bids that underlined the value that exists among UK assets. Luxury confectioner Hotel Chocolat saw its share price almost treble following interest from Mars. Bowling alley operator Ten Entertainment Group received a bid at a 33% premium to the current share price, while City Pub Group was also targeted by Young & Co’s Brewery Plc at a significant price premium.
A lot can change over the course of a month. Whereas back in October, the markets were spooked by the prospect of rates remaining ‘higher for longer’, now they are convinced they’ll be cut significantly in 2024. Recent weeks have seen a change in rhetoric from central banks, with the hawkish messaging that has dominated much of the past two years finally softening. As a result, traders have pivoted rapidly to price in more than a full percentage point of cuts in US interest rates over the coming year, starting in March. This is despite Fed Chair Powell’s insistence that policymakers have yet to discuss the possibility! Markets are also expecting the ECB to mirror this move, with the Bank of England cutting slightly less and slightly later in May.
These latest predictions may prove a little over optimistic; the big post-covid forecasting misses of markets and central bankers alike suggests one should treat forecasts with a large pinch of salt. Nonetheless, the direction of travel is clearly down and it’s hard to argue against the idea that we’re in a better place today than when we entered 2023.
November was a great example of the merits of staying invested and not trying to time the markets. It has highlighted the speed at which markets can move and the need to be positioned for the medium term. With confidence growing that central banks will be cutting rates next year, the outlook for both equities and bonds is more appealing than cash.
The US has been a standout performer among global equity markets in recent years. Its outperformance has been led by the ‘Magnificent Seven’ technology giants of Apple, Amazon, Alphabet, Nvidia, Meta, Microsoft and Tesla. While these are undoubtedly world class companies, they are currently priced for perfection, commanding a massive premium over other US listed stocks. In market cap terms they now make up more of the world index than Japan, the UK, China, France and now almost Canada too, combined. In an uncertain environment, investors have sought refuge in these household names. However, attention should switch to cheaper assets that can benefit to a much greater degree from a recovery as rates fall. Our standard portfolios are overweight markets outside of the US such as the UK, Japan, Asia and emerging markets, where the outlook is much more compelling in this regard.
No one would really debate that UK equities are cheap right now. The market has been unloved since the initial Brexit vote in 2016 and currently trades below 10X earnings, near the bottom of its 30-year trading range and on a significant discount relative to other major markets. The good news is that its underperformance bottomed out in mid-2020 and so, after a very bad period, things may be looking up. The recent strong move up in UK small caps is encouraging. The valuation disparity between small and large caps has rarely been this large: UK small caps are now priced at 8X earnings, and these earnings continue to grow. They have only been cheaper on an absolute basis in 2009 and the period from 1979-1981. In the US, the index was similarly cheap in 1980 but has since risen to a multiple of around 20X earnings. As economic conditions continue to normalise, this gap should narrow, allowing the outperformance of value stocks that occurred in 2022 to resume. We recognise the need for patience, but the margin of safety is reassuring and provides scope for outsized gains once the outlook improves.