A much needed ray of light going into year end
How long the period of heightened inflationary pressures will last and consequently for how long interest rates will need to remain at their present or even higher levels, has continued to dominate the conversation in financial markets this year. The formal rhetoric from the major central banks, the Federal Reserve, European Central Bank and the Bank of England, has been uncompromising and consistent – there will be no early let up in necessary monetary pain. But following the release of inflation figures from the US and UK, in mid-November, hopes that an easing in rates might be brought forward, have gained a glimmer of traction.
The annual US Consumer Prices Index dropped to 3.2% in October, down from 3.7% in September, a larger fall than had been expected. On a monthly basis prices were flat and that too was a welcome development, a significant change from what was being seen earlier in the year. In the market session that followed, bond prices jumped, pushing down the yield on US 10-year Treasuries by around 20 basis points to 4.4%, and the stock market rallied strongly, with the US S&P 500 index up 1.8%. Smaller company shares performed even stronger on the day with the Russell 2000 index jumping by some 5.4%.
Hot on the heels of the US data, the UK delivered its own surprise – the steepest single one month decline in the consumer prices index since 1992. Inflation fell from 6.7% in September to 4.6% in October (year-on-year), beating Reuters consensus forecast for a 4.8% reading. At the beginning of 2023 inflation had stood at 10.7%. As in the US, UK financial markets responded with a strong bounce. Homebuilders were among the largest gainers on the FTSE 100 that day (15 Nov), adding 2%, while banks gained as much as 1.6%. UK smaller company indices did much better than the FTSE 100 in this rally.
A challenging year for small caps in particular
Tighter monetary policy has been unhelpful for equity market sentiment and valuations in 2023 and it has been a challenge competing for investors’ capital against a backdrop of higher investment yields on bonds and more (relative to the last decade) attractive returns from deposit accounts. Amid the risk averse mood in the stock markets, as is usually the case, smaller companies have tended to lag the larger names in most parts of the world. Within the small cap space, the UK market has underperformed many of its peers (excluding Europe) as the phased rolling off from fixed rate mortgage deals from the low rates of a few years ago has hurt the housing market and suppressed activity, impacting the construction and related sectors. This in combination with general inflationary pressures has also dented general consumer sentiment. Nevertheless, many of our holdings have navigated this tricky environment well and have produced solid returns. Indeed, some such as Lancashire Holdings in the insurance and reinsurance business have benefited from the higher interest rates in terms of the returns that they have been able to generate from their balance sheet, alongside strong underwriting results stemming from the inflation that they have been able to pass through to their insurance premium pricing.
The hope from here for investors, and especially those investing at the smaller company end, is that we could be heading towards a period in which interest rates can be lowered given the easing in inflation. As well as being good for stocks, the improvement in the inflation numbers could also help to narrow investment trust discounts which have widened during 2023.
Beaten up stocks could benefit from improved inflows
While inflation has moderated, and this is a welcome development, we remain aware that the headline rates are still materially above central bank targeted levels so although rates may now not need to be kept high for so long, a loosening of monetary policy is not yet a slam dunk.
In terms of our investment strategy, we have been looking in recent months to increase our exposure to companies that might be beneficiaries of a turn in the interest rate cycle. A number of companies in the construction arena including landscaping and roofing products supplier Marshalls have faced tough trading conditions amid the downturn in the housing market and their shares have been sold down to what we see as attractive levels taking a longer-term view. Commercial real estate has also been weak in a rising interest rate environment and we have taken the opportunity to increase our exposure to holdings such as Workspace Group (which rents out space to small and medium sized enterprises on a flexible leased basis in London and the South East ) and in the US, Healthcare Realty, which owns a national well invested medical property portfolio which will benefit in the medium term from positive demographic trends. We feel that both have scope to rebound as interest rate fears subside. Another recent new position for us has been Foresight Group Holdings Limited, an asset management business focused on private equity, infrastructure and other niche areas such as forestry. This company has delivered strong long-term growth by launching new funds across a broader pool of asset classes and should be well placed too to continue its organic growth especially in a lower interest rate environment.
The mention of any specific shares should not be taken as a recommendation to deal. Columbia Threadneedle Investments does not give any investment advice.
Looking forward therefore we are optimistic that there is value in the global small cap universe, especially in interest rate sensitive parts of the market. It remains unclear exactly when the rate environment will change so in the meantime, we need to retain a well-diversified portfolio, with a focus on high quality, well managed businesses which have strong balance sheets to enable them to navigate their way through the current more challenging economic times.
