Great Expectations

We‘ve probably all experienced this. You look forward to something only to find that it does not live up to your expectations, particularly holidays. If you pay for a 5-star hotel then you want 5-star service and if the destination is overseas, you also expect cloudless skies and unbroken sunshine. The disappointment is therefore far greater if the hotel or weather is poor. Conversely, if on holiday in the UK then you may be prepared for some rain. If the weather turns out to be dry and sunny, it can be an unexpected bonus.

What has this to do with investment? Well, the stock market is all about expectations. A company’s business activities, management, track record and finances are all baked into the stock market valuation. Fund managers are typically looking 12-months ahead, and by using current trading and guidance from management teams, they combine this with the wider macro-economic picture to take a view on the likely outcome ahead. Typically, the more cheaply rated companies or ‘value stocks’ have lower expectations baked in, possibly due to government regulation, economic cyclicality or limited order visibility. The more highly rated or ‘growth companies’ typically trade at a premium, reflecting faster rates of growth. This could cover new growth markets such as big data, artificial intelligence, renewables or disruptive technology.

Here lies the problem. The higher the valuation, then the greater the market expectation, so that any disappointment in the rate of growth can lead to a significant adverse share-price reaction. Likewise, value stocks could be pricing in such a disappointing outlook that when results are not as bad as feared, the shares can see a relief bounce. In the long-term, the ‘best’ management teams tend to be those that ‘under-promise’ and ‘over-deliver.’  

Markets have ‘great expectations’ of a ‘Fed pivot’ during 2023 after a series of aggressive interest rate hikes. No wonder the US Federal Reserve (Fed) is trying to stop investors getting too excited about a ‘pivot.’ Meanwhile, UK equities have been in ‘value’ territory for some time due to Brexit/politics/cost-of-living crisis/stock market composition, but have recently hit a four-year high on hopes that the expected economic downturn may not be as severe as forecasters envisage.

 

What have we been watching?

 

There is growing optimism that a severe global recession can be avoided and certainly the mild weather across Europe has been helpful with gas prices continuing to fall. In addition, while China faces a tough start to the year with Covid-19 ripping through the population, its economic growth rate is expected to improve during 2023 as the country exits lockdown. While China will support the global economic outlook, it may also create some inflationary pressures if there is a release of pent-up demand as seen in the West. Even the IMF has become more positive, signalling it may upgrade its global economic forecasts. Instead of predicting a ’tougher’ 2023, the IMF is now expecting an ‘improvement’ in the second half of the year and into 2024. The IMF expects the Chinese economy will see a significant improvement in 2023 and acknowledged the support from the Biden administration’s Inflation Reduction Act, a $369bn bid to stimulate green investments in the US economy. Meanwhile, there has been a U-turn in sentiment amongst European economists. Having predicted the EU bloc would plunge into recession in 2023, the latest survey by Consensus Economics suggest that the region could avoid recession this year albeit with growth of just 0.1%.

Clearly some global headwinds remain, primarily the war in Ukraine, while central bank messaging about interest rate policy is still proving to be mixed – the European Central Bank and Bank of Japan being prime examples. The good news is that inflation looks to be heading lower although the bad news is that some elements such as food are proving ‘sticky’. Could this ‘sticky inflation’ cool premature speculation about the pace of interest rate hikes?

With hopes of a slower pace of interest rate hikes by the US Federal Reserve, the UK inflation and wage data saw Sterling rally to $1.24, which saw UK equities pull back from their recent high due to some inevitable profit-taking amongst the overseas earners. Given the amount of goods the UK imports, then the continued recovery in Sterling may help on the inflation front.

While gas prices have fallen, which is helpful for the inflation outlook as well as government finances, food prices are likely to remain elevated. The boss of Yara, one of the world’s largest fertiliser companies accused Putin of ‘weaponising food’. The cost of fertiliser will remain very high which will be an ongoing threat to food production and therefore food prices in 2023. UK food inflation hit almost 17% in December.      

The US expressed concern about joint military manoeuvres by Russia and Belarus, although added that there are no indications that Belarus itself is planning to invade Ukraine. Meanwhile, Germany has still not given approval for the supply of its Leopard battle tanks to Ukraine but suggested it might if the US in turn makes available its Abrahams battle tank. Meanwhile, thoughts are beginning to turn to the re-construction of Ukraine with the European Council president calling for a debate on the £300bn of confiscated Russian assets held in western banks.

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In the UK, many elements of the latest employment data suggest the jobs market may be softening with vacancies declining and redundancies increasing, although private sector pay is still growing strongly at an annualised 7.2%. Meanwhile, inflation is starting to ease as expected although lacking the pace of decline seen in the US and Europe. Helped by lower petrol prices, December CPI dipped slightly to 10.5% although some elements remain ‘sticky’, with food inflation up by almost 17%.

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In Europe, more central bank mis-direction? Following weeks of ‘hawkish’ comments from some members of the European Central Bank (ECB), there were media reports that a reduction in the pace of interest rate hikes is now being considered for as soon as the March ECB meeting! Eurozone inflation dropped to 9.2% in December as expected, helped by lower energy prices, although price increases in some areas such as services remains ‘sticky.’

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In the US, hopes remain of a slower pace of interest rates by the Federal Reserve as economic conditions become more challenging. The Empire State manufacturing index revealed a sharp contraction in business activity in New York State with firms expecting little improvement in business conditions over the next six months.

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The Bank of Japan (BoJ) announced no change in policy and so, expect it to have to keep buying more bonds in the short-term. The Yen fell back on this news. The BoJ is now believed to own over 50% of Japanese government bonds, so the ongoing yield ceiling target is becoming more unsustainable. The BoJ will see a new governor in April which is a likely trigger for more policy change.

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China’s economic growth in 2022 was 3%, the weakest since 1976 and excluding the Covid-19 period. However, this was not as bad as feared (see above!) with the same to be said for the monthly business activity indicators in December. Many factories are having an extended shutdown over the Lunar New Year break to help combat Covid-19 infections. The first quarter is likely to be challenging due to the spread of Covid-19 but China’s economic growth rate is expected to increase to 4.9% in 2023 as the country emerges from lockdown.

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Brent oil edged upwards to $87 as the IEA (International Energy Agency) said it expects the re-opening of China’s economy to drive nearly half of the global oil demand growth this year to a new record high.

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Finally, everyone knows a new car starts depreciating in value the moment you take delivery. Unfortunately for very recent new owners of a Tesla this has been over £5,000 in less than 24-hours after the company announced a surprise cut in UK prices of new models of between 10%-13%. When demand for Tesla cars exceeded supply, the company was able to maintain prices at what Elon Musk himself described as ‘embarrassing levels.’ Growing competition and pressure on consumer spending for ‘big ticket’ items has changed this. Tesla shares were a must have a while ago but have depreciated faster in value than a Model Y with a 65% fall since Spring 2022. With the benefit of hindsight, perhaps it was the Tesla share price that had reached ‘embarrassing levels?’

Read Last Week’s Alpha Bites – Blown away

 

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Alpha Portfolio Management is a trading name of R C Brown Investment Management PLC which is authorised and regulated by the Financial Conduct Authority.