Stick or Twist*

It is only because of the strength of the US Dollar (and sterling weakness on top) that returns for some Dollar priced assets, mainly US equities and commodities were positive in sterling terms. Over the quarter the FT All Share Index fell 3.45% whilst the FTSE All World Index fell – 5.22% in local terms but gained 1.42% in sterling terms. Bonds, which traditionally are the defensive assets in portfolios actually fell more than equities. Gold, which is often a hedge against inflation did not perform as expected falling -7.6% but as Gold is priced in Dollars it generated a positive return in sterling terms. These returns illustrate the benefits of diversification – one of our core beliefs These declines are despite a very strong rally in equities and to a lesser degree, in bonds in July. The driver of that rally was a perception that the US Federal Reserve (Fed) was going to reverse course and cut interest rates in response to softer economic data. The fabled Fed Pivot. This was subsequently quashed by comments from Jay Powell (the Fed Chair) and by data which showed that headline inflation in the US, whilst no longer accelerating is remaining stubbornly high. Core inflation (excluding the volatile elements of food and energy) is still increasing. The focus of most market commentators is predicting when US inflation will peak (and there is a reasonable expectation that we are near the peak) which will be interpreted as the giving the Fed room to pivot. Following recent inflation data, the market is now discounting further rate raises before the year end. The Fed is then likely to stick i.e. pause rather than pivot, holding interest rates and waiting to see the effect on the real economy.

We mentioned last quarter that the risks of recession were increasing, and this remains the case. So far profits, especially in the US have held up reasonably well and most, if not all of the equity market’s decline can be attributed to a fall in the value that investors place upon future earnings. The upcoming results season will be important in signaling the impact of rising costs and interest rates on corporate profitability. We recently met with one of the fund managers – Dodge and Cox who are primarily bottom-up stock pickers. Our conversations focused on how they factor in the macro environment into stock analysis. They scenario test their assumptions and even with quite bad worst-case assumptions they are still finding companies with good long-term prospects and
following recent declines, attractive valuations.

A lot of our thinking focuses on the US which is understandable given the size and role of the US in the global economy and global markets. However, we cannot ignore the turmoil in the UK. Last quarter we reprised Warren Buffet’s famous quote about when the tide goes out and we may have just got a glimpse that it was Britannia bathing in the buff. A lot has been written about the crisis in long dated Gilts (UK government bonds) caused by the mini budget. This has a direct impact on Defined Benefit (DB) pension funds that have embraced Liability Driven Investment (LDI). This does not apply to your SIPP invested with Cavendish Ware which is a Defined Contribution (DC) pension. However, this episode has caused both volatility and more importantly a rise in long dated (over 15 years to maturity) gilt yields which move inversely to price. So the price of long dated Gilts has fallen quite sharply. This then effects corporate bonds because they are valued with reference to the yield on the equivalent maturity Gilt i.e. the “risk free” bond for that maturity. The good news is that we have been bearish on bonds for some time and especially longer dated bonds (not that we expected this crisis!). We are materially underweight bonds and do not hold long dated bonds. Whilst all sterling bond prices will be affected by this turmoil the bond exposure in all our client’s portfolio has been relatively unaffected. However, if the price of Gilts falls further it may present an opportunity to start buying.

* I was referring to US interest rates but could equally refer to UK Chancellors