Current market turmoil has its roots in the stability of the past decade

The lesson for investors from the economic, financial and, of course, political turmoil of recent months is we cannot know where the next crisis will come from

24/11/2022

Andrew Williams

Andrew Williams

Investment Director

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“There are decades where nothing happens; and there are weeks where decades happen.” No – this quote tends to be attributed to Lenin and so was not formulated to describe the intense period of economic, financial and, of course, political drama-turned-farce experienced by the UK as summer turned to autumn. Still, it easily could.

The final week of September saw UK gilt yields rocket after a disastrous reception to new (wait, former …) chancellor of the Exchequer Kwasi Kwarteng’s unfunded tax giveaway. This triggered a shockwave for UK pension schemes that use so-called ‘liability driven investment’ strategies – where derivatives allow the giant funds to increase their exposure to gilts, without necessarily needing to own them outright.

Ultimately, the Bank of England splurged £65bn to provide liquidity to the gilt market and halt a potential downward spiral. This represented a dramatic finale of increasing macroeconomic uncertainty in a quarter that saw inflation morph from ‘transitory’ to ‘definitely here’ and, not unconnectedly, interest rate expectations move higher at record-breaking pace.

Over the first nine months of 2022, the 30-year gilt index dropped 43% and the 25-year index-linked gilt 58% while sterling fell 18% against the US dollar. This currency weakness continues to fan the flames of inflation in the UK – the Bank of England’s response to which is the sledgehammer policy tool of raising interest rates, thereby increasing recession risk further.

‘Paradox of tranquillity’

It almost goes without saying that markets are stressed and investors nervous – and it is at times like this that Hyman Minsky’s ‘paradox of tranquillity’ comes to mind. This holds that stability itself creates instability because investors, presuming the future will be as benign as the recent past, take on more risk, which in turn increases the risk that volatility will cause instability in the financial system.

A significant indication of this came in late September as gilt yields moved more than a percentage point in the space of just a few days. Based purely on years of benign financial conditions, some UK pension funds had looked to match their assets to future pension payments through borrowing or ‘leverage’ in a way that did not fully respect the possibility such wide swings could occur. And then they did.

The lesson for investors of all shapes and sizes is we cannot know where the next crisis will come from. What we can argue with a degree of certainty, however, is that more than a decade of cheap money flows – which central bankers switched on in response to the 2008/09 global financial crisis but later struggled to find the collective will to switch off – has caused the build-up of risks in other corners of the financial system.

Rigorous analysis

There is some good news in all this, though. Equity investors can protect themselves by focusing only on stocks with genuinely attractive valuations and, through rigorous analysis, purchasing only those with sufficient balance-sheet strength to see them through whatever lies ahead. As we have consistently argued, here on The Value Perspective, it pays to be prudent.

In the face of this – at least at the headline level – the UK equity market’s performance has been admirable. As the following chart illustrates, over the first nine months of the year, it has outperformed most major global markets in US dollar terms –  although that headline number posted by the UK masks a huge gap between the performance of companies in different size groupings.

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As an example, in sterling terms, the FTSE Mid 250 index fell a whopping 25% over the period while the FTSE 100 dropped just 3.5%. The next chart shows both the relative performance of those two indices as well as the pair’s drawdowns versus the trailing peak. As you can see, we have just hit the largest drawdown in recent history – surpassing even that of the global financial crisis.

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This differential in performance between the UK’s very largest businesses and the next 250 means the opportunity set for value-oriented investors is rapidly changing. Put simply, there are a lot more stocks to review for UK investors today and, as the above chart suggests, these newer ideas tend to be mid-sized cyclical businesses. That said, while there may be plenty of opportunities, only fools rush in.

Process as guide

Here on The Value Perspective, our process is our guide. One of our seven ‘red questions’ centres on balance-sheet strength, which we interrogate before buying into any business. This focus on truly understanding a company’s financial position is important at the best of times – and even more so in the current environment. As ever, we will only add exposure where we are compensated for the potentially turbulent times ahead.

Take UK banks, which we currently view as an extremely attractive sector. There is no doubt the risk of recession is real but most banks are now back in a position where they can comfortably absorb materially higher credit losses without upsetting capital buffers or the value case. Moreover, the tailwind to net interest income from higher interest rates for most banks is enormous.

In an environment where moves in sterling and gilts have been an uneasy reminder of previous emerging-market crises, there is no doubt we are living though uncertain times. Over recent years, however, we have taken advantage of valuations to increase diversification and our process has meant we have avoided many of the stocks that have fared the worst in this drawdown. We are also being cautious as we lean into areas that should benefit our investors greatly over the coming years – even if that may feel uncomfortable today.

Author

Andrew Williams

Andrew Williams

Investment Director

I joined Schroders in 2010 as part of the Investment Communications team focusing on UK equities. In 2014, I moved across to the Value Investment team. Prior to joining Schroders I was an analyst at an independent capital markets research firm and hold a Economics and Politics degree.

Important Information:

The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German, Tom Biddle and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.

They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

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