Economist Q&A – With Michael Hughes

Following the mini budget delivered by UK Chancellor Kwasi Kwarteng, financial markets have suffered a downturn in fortune. The Bank of England have since stepped into the marketplace and purchased £65 billion in government bonds to protect pension funds.

As financial advisers, we understand any concerns investors have about how their retirement plans might be affected. With our investors in mind, we spoke with our Economic Adviser – Michael Hughes to discuss several areas of interest to investors right now.

Michael has an impressive resume and brings outstanding investment experience spanning more than 30 years to our investment committee.

From 1998 until December 2007, Michael was Chief Investment Officer and a Director of Barings Asset Management. Prior to this he was a Managing Director at Barclays Capital, Chairman of Barclays Capital Pension Fund and Executive Director of BZW Gilts Ltd.

Between 1997 and 2006 Michael was a Council Member of the University of Essex and a contributor to numerous newspapers and TV programmes. In addition to his work in the private client sector, Michael also advises Charities, Pension funds and family Trusts.

Should you have any questions regarding your investment portfolios after reading this, please do not hesitate to contact us.

 

What do you think about current events and how concerned should investors be?

Previously I have highlighted the difference between risk and uncertainty. Risk can be measured, and a probability assigned to various outcomes.

Currently we can be reasonably sure that interest rates are going higher worldwide and although we do not know how high, we can have a reasonable guess that they will peak at around 4%.

Any higher and the central banks risk having a deeper recession with increased financial instability. Remember they have a mandate to keep inflation under control, and also control financial risks.

The uncertain elements continue to include how the Ukraine situation will unfold, whether China/US tensions will intensify, how long-term energy supplies can be secured and whether we can protect ourselves against new pandemics.

Assigning a probability to these is virtually impossible. Similar situations occurred in the past e.g., during the oil crisis of 1973/74 and during the financial crisis in 2008/09.

In this environment we have tried to make our portfolios resilient e.g., having high cash weightings to ensure some protection, but also keeping our ‘powder dry’ to utilise when the uncertainties reduce, and markets regain their confidence.

We have also protected ourselves from inflation by increasing real assets and reducing financial assets such as equities.

The risks are not yet reducing so we have retained this defensive stance, but we have also set criteria to put risk back in to the portfolios if conditions improve.

We continue to monitor positions but have not seen any positive signs to assign additional risk.

 

What if conditions deteriorate more than we anticipate?

We are long-term investors and believe there is a new investment cycle commencing with increased spending on defence, infrastructure, healthcare, and alternative energy supply. These trends continue to look favourable.

They should continue to help counter any cyclical slowdown unlike in the past when both trends and cycles deteriorated together producing deep recessions.

 

Is there a precedent to these events? If so, what lessons can be taken from them?

As I indicated above there were precedents in terms of great new uncertainties in 1973-74 and 2008-09. Each led to great changes in terms of energy efficiency and stronger balance sheets for banks and controls on their risk taking.

This time, although the factors are different, great changes can be expected yet again.

New vaccinations are being developed with the technologies applied to Covid solutions, leading to new discoveries applicable to other diseases.

Defence spending is planned to rise throughout the Western world, but for the first time in a generation, in Japan and Germany new weapon systems are being developed.

The creation of alternative energy sources and great power storage together with improved energy security is also now galloping ahead.

Infrastructure to improve health and education facilities and the rise of new technologies to improve lifestyles is also evident.

 

Are there any positives to take from the sell-off across nearly all asset classes?

Whilst many may not see this as a positive, company valuations are more realistic.

We have lived with low interest rates for so long now, people have forgotten what ‘normal’ valuations look like.

In some areas we are not quite there yet e.g., housing, but credit spreads now reflect the risks inherent with a mild economic slowdown and inflation may fall away faster than currently seems likely, even if the core rate may still remain 3-4% i.e. higher than central bank targets.

We are also seeing greater policy divergencies across the globe and between sectors, which increases diversification benefits, in turn helping those trying to diversify risk.

 

Where do we see interest rates going and what impact will this have on the housing market?

As mentioned previously above, I see rates going to around 4%. The housing market may be affected more by the reduction in the supply of mortgages than the increase in interest rates. Also, the house price to average earnings ratio is far too high. We see this adjusting by earnings beginning to rise more than inflation, and house prices reducing a bit. Please note, I do not see a house price crash occurring.

 

Conclusion on current events?

There is no hiding the fact that the fallout from the mini budget has left many unknowns, specifically in the UK. It is not yet known by the government, let alone global counterparts whether the moves by the chancellor will work or how they will be paid for in the long run. This has resulted in lower financial markets in the near term. But this is not anything uncommon where investing is concerned.

Whilst this situation continues to evolve, and become better understood, the short to medium term directions of both markets and the global economy are still a little unknown. With the recent increase in food and energy prices somewhat suppressing global economic activity, the role of central bankers to protect the economy becomes more difficult. The mini budget has not helped matters.

In short and to put bluntly, the largest macroeconomic drivers remain full of uncertainty at present, and we will continue to monitor the situation very closely.

It is important to note that our portfolios are constructed with diversification at the forefront to limit as much downside risk as possible, but during systemic events such as this, it can be difficult and near on impossible to come out unscathed. It is important to not let short-term decisions impact long-term growth.

We believe in ‘time in the markets’ over ‘timing the markets’ and if we look back through history, this approach has worked.

Our long-term views have not shifted and we continue to believe our portfolio’s are best positioned to help our clients meet their long term investment objectives. For now, we will watch the developments in the economy and wait before making any major decisions.

We will continue with our tactical investment approach and keep to our core investment philosophies of seeking to help our clients meet their investment goals, mitigating inflation risks and protecting against major market movements.

Please do not hesitate to get in touch if you have any further questions.

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