Break Point, Expectations & Recovery

“If you accept the expectations of others, especially negative ones, then you never will change the outcome.” Michael Jordan

“The whole point of rugby is that it is, first and foremost, a state of mind, a spirit.” Jean—Pierre Rives.

Halfway through the year and midway through Wimbledon fortnight and another familiar Ashes test series, it is time to take stock. Financial markets and our Summer sports have been exciting but have yet to feature domestic success. Some of us will keep our patriotic fervour for later in the year when the Rugby World Cup kicks off in war-torn France—albeit as an England fan, this represents a victory of hope over all rational expectation.

So far in 2023, markets have had more vital signs than last year. Although consumers and policymakers worry about inflation, markets have moved on and have become more concerned with recession, financial stability and solvency. Widely anticipated, the recession is proving elusive as most output and employment measures are far more resilient than expected. However, rapid rate rises also increase the risk of excessive policy tightening, increasing the intensity and length of the inevitable slowdown. This is the breakpoint we now face.

The Silicon Valley Bank and First Republic dramas seem long ago. The immediate concerns over global financial stability have subsided, reflected in the 10% fall in the dollar price of gold. But, as rate pressures have grown again recently, we are reminded that the consequences of monetary tightening are long and variable. The list of the next things to break grows with water utilities, professional rugby clubs, and PE returns all featuring.

Unsurprisingly, financial markets’ base case expectations are for an economic slowdown. Negative forward indicators include downward-sloping yield curves, declining energy and industrial material prices, falling producer prices and a faltering Chinese recovery. As a result, most large investors remain cautiously positioned with lower-than-normal risk asset exposure and higher-than-normal cash holdings, meaning illiquid risk assets, such as UK mid and small-caps, remain attractively valued. Albeit, things can get worse before they improve.

Although policy rates continued to rise in H1 2023, financial conditions eased as the Federal Reserve provided monetary assistance to its regional banks, and the US Treasury wound down its General Account in the run-up to June’s successful debt ceiling negotiations. A softening stance from Beijing has also boosted liquidity in recent weeks. The POBC has lowered some rates and eased reserve requirements to try and re-ignite the stalling recovery.

The extra liquidity has helped fuel the search for enhanced returns from generative AI, which burst into mainstream consciousness following the rapid adoption of Chat GPT—a trend captured by Nvidia becoming the world’s first trillion-dollar semiconductor company. As a result, NASDAQ, the S&P 500, and Japan’s previously unloved stock market were all up comfortably by double-digit percentages in the period. However, currency movements mitigated returns for UK investors as the Dollar (-7%) and the Yen (-15%) weakened against a stronger Pound.

It was disappointing but unsurprising that investors didn’t view UK equities as an attractive haven in this period. Concerns about the UK’s inability to contain inflation mitigate against global investors allocating to UK equities. Despite this, returns were broadly flat in dollar terms, and various bodies, including the OECD, IMF and OBR, upgraded assessments of the UK’s economy YTD.

In the debate about London’s suitability to attract capital, two high-profile IPOs announced their intention to float. Turkey-based commodity chemicals supplier WE Soda soon withdrew, citing disappointing valuation feedback without mentioning its well-documented governance concerns. However, the smaller but more exciting CAB Payments (not a taxi fare app but the revived Crown Agents Bank repurposed as a modern payments provider for emerging markets) progressed to IPO.

There was a noticeably diminished impact of PE-backed bids in Q2 as the Q1 flurry faded. Higher interest rates negatively impact PE returns, and the recent spike in UK rates may have tempered PE appetite. Despite this, EQT’s substantial offer for Dechra was revised but looks like completing, while offers for Wood Group and THG failed to materialise. Meanwhile, the unexpected £450m offer for Lookers from Canada’s Alpha Auto and AB Foods’ offer for National Milk Records indicate that UK assets remain attractive but unpredictable targets for corporate buyers.

As investor fears rotate from duration to recession, the equity recovery has focused on AI, US large tech and Japan as safe havens. However, there is increased evidence that the recovery is starting to broaden. With Japan rerating, thanks partly to Warren Buffet’s recent buying spree, the UK looks increasingly isolated as the final value equity play in developed markets. While any recovery is unpredictable, falling inflation and the end of rate rises would be helpful, but that is a few months off.

Sporting success, like stock market success, is cyclical, and France is the well-deserved favourite for this year’s Rugby World Cup. With three of its thirteen top-flight clubs folding in the past year, the English game is in a similar predicament to the London equity market. With more rate hikes imminent, rugby club and listed company solvency will yet worsen. However, expectations play a significant role in determining market and on-field success. Expectations for the UK stock market and the England rugby team are at ground zero. Looking for recovery catalysts is often less effective at times like this than adopting a nothing-to-lose, never-say-die mentality. Here’s hoping.

Jeremy

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