Earlier this year I wrote two pieces about the outlook for 2023 and whether portfolios would generate a positive return in the calendar year.  I wrote the second article in late February and markets had got off to a nice start to the year.  Then we had the collapse of SVB Bank in California and things have been a struggle since.

The article highlighted that short-termism, lack of planning and emotions when investing can cause problems.  I also said that my football team, Leicester City, unlike most English football teams still had the same manager that we started the season with.  Things can change quickly!

Current situation

It’s been a frustrating start to the year and we’re in this awkward period, where positive economic news is seen as a negative by investment markets.  As we went into the Autumn last year, the UK economy looked awful and estimates were for a 30-40% drop in company earnings in 2023.  Roll forward to today and it looks increasingly likely that the UK won’t be in recession this year and estimates have risen markedly for the economy.  That positivity hasn’t yet been reflected in the valuation of listed small and medium sized businesses.  Part of the issue is that investors are transfixed on inflation and the impact for interest rates.

Inflation Expectation

The UK economic environment being more positive than we thought this year has meant that the expectations for inflation has somewhat changed.  Following the mini-budget last year and the economic shock it created, the logic was the consumer demand would wane and it hasn’t.  This has led to a stronger than expected jobs market.  Whilst this is all good news for the economy, it isn’t helpful for the Bank of England’s 2% CPI target.  Good news for the economy means higher interest rates.  So, whilst it takes around a year for the effects of an interest rate rise to change economic conditions, the Bank of England (BoE) look set to keep rising interest rates.  At their last meeting the BoE stated “CPI inflation had been stronger than expected, owing to higher food and other goods prices”.  My concern is that the BoE might be making mistakes by pushing up interest rates much more.  Interest rates won’t directly affect the 19% rise in food prices that they are referencing.  The BoE are changing interest rates based on things out of their control (food prices) to try and affect today’s inflation rate (more short-term planning), yet the interest rate rises will affect conditions in a year or so’s time (when they expect inflation to be 0.4% above their 1-3% inflation target range).

What is the impact of higher interest rates in the UK?

We don’t yet know the impact of higher interest rates in the UK as it takes time to feed through, especially as the majority of mortgages are on fixed rates.  Inflation is falling and will continue to fall this year.  If the BoE keeps raising interest rates, it will create unintended consequences and will increase economic risks.  This is why markets haven’t reacted positively to the better-than-expected economic data.

We are increasingly seeing and hearing positive operational updates from the management teams we invest in.  This is creating large differences between the independent valuations and operational updates and the valuations that investors are putting on the assets.  This difference will be realised, it’s just a matter of time and how quickly it happens.

How optimistic are we?

Do we get a positive return for 2023?  We remain optimistic that we will.  However, as mentioned in the last article, it remains the wrong question.  Valuations point to attractive potential returns over the next three years for those that are planning for that sort of time-horizon.

If you want to understand our portfolios or how we combine financial planning with investment management, please get in touch with any of the team.

Thanks for reading and enjoy the journey!