Watching the market; waiting on the economy
What are the changes that I’m looking for? Well, the key fundamentals are inflation, interest rates and the economy, which is best summed up in the question – will we have global recession in 2023? But there’s also markets. While equity markets have moved a long way this year, they still don’t discount a recession in 2023. And that’s because we don’t know whether there will be one. If markets did move to a level that did discount a recession, then clear opportunities would arise.
We’re on recession watch for 2023
Recession is a clear risk for 2023. We will find out more about the likelihood of a recession by the end of the year. That will also guide the likely course of inflation and interest rates. While the energy shock to European economies, including our own, means that some countries may tip into recession this year that is likely to be shallow and temporary.
For wider global recession risks, we need to look at the fortunes of the US economy. Here, energy self-sufficiency means that the economy is still growing strongly, despite the reported blip from trade flows in the first quarter, and the key risk is the rapid rise of inflation and how far the US Federal Reserve may need to raise interest rates to bring it under control. All this is too far away to be clearly forecast, we can only be aware of the risks and look for turning points in the economic data.
When the news on the economy becomes clearer, markets will not only move to discount the impact of a recession, but also then start to reflect the expectation of economic recovery beyond.
Markets have moved significantly in 2022
Equities have moved a long way in 2022. While UK large indices are still ahead, that reflects the fall in sterling and their heavy weighting to oil and miners. Mid and small cap UK indices are down by around 10% and discounts for investment trusts have widened in most areas. The best-known technology investment trust, Scottish Mortgage, lost more than half its value at the low point.
There have also been significant moves within markets. Large-cap, defensive, income, inflation-protected and commodities are the areas that have held up best or even made gains in the current markets. Small and mid-caps, technology, growth, and stocks with poor liquidity have suffered as investors have become more cautious. Taking the example of private-equity investment trusts, it is easy to say that discounts of up to 35% on net asset value are already reflecting the worst, but those funds are still to report the full scale of the hit to their assets from market moves.
Elsewhere there has been uncertainty over whether traditional defensive areas, like branded consumer goods companies, will be able to pass on inflation and so maintain profitability. In contrast banks are doing rather better than might have been expected, as rising interest rates come as a welcome relief after living with near zero rates for so long. However, rising bad debts are still a risk to profits as the economy slows, even if capital ratios and recent controlled lending growth suggests that they are better placed to weather any recession.
How can you tell if markets have discounted bad news?
Markets continue to punish companies with poor results. That tells us that disappointing outcomes are not yet priced in. While the market has already moved a long way, to increase my appetite for equities I need to see that markets are discounting the worst outcomes, or to wait for the actual outcome to become clearer.
In the meantime, we think that equities now reflect fair value, so I am happy to remain invested on that basis. Dividend yields are at attractive levels and set to grow. Therefore, as the portfolio has been structured to ride out current trends, I have made no significant changes in recent months.