Charlie Huggins, Head of Equities at Wealth Club, the online wealth manager shares his views on how investors might navigate the economic uncertainty and inflationary pressures that lie ahead in 2023.
Charlie will be launching a discretionary share portfolio for Wealth Club clients in the new year.
Don’t be put off by gloomy economic headlines
It’s widely expected that the global economy will weaken in 2023, and an extra dollop of doom and gloom has been penciled in for the UK economy.
It’s not difficult to see why. High inflation and rising interest rates act as a handbrake on businesses and consumer spending. However, most experts agree that the stock market has already factored in this prevailing sentiment.
Cyclical sectors like housebuilding have fared very poorly in 2022 – Persimmon shares have halved, for example. But this means there’s a lot of bad news already in the price. Builders could stage a recovery, even if the housing market falters in 2023, just as long as house prices hold up better than people are currently expecting.
The same applies to the economy as a whole. A shallower recession and some easing of inflation could easily see a rotation from classically defensive areas to more cyclical, beaten up areas like retail. In fact, we have already seen some of this in recent weeks.
The key thing to bear in mind is that the economy and stock market aren’t the same thing. In 2022, the economy has held up rather well, whereas stock markets have struggled. Be very wary of basing investment decisions on economic headlines.
The era of free money is over
The period of rock bottom interest rates and low inflation since the 2008/09 financial crisis ended in 2022. It seems unlikely we’ll go back there any time soon, even if many younger and less sophisticated savers, for which this was the new normal, are living in hope of a return.
This has big implications for companies and investors.
Very cheap borrowing costs meant companies and investors were awash with spare cash, while the lack of return on cash and bonds, forced investors to look elsewhere for returns. That created all sorts of excesses, with soaring prices for bitcoin, meme stocks and loss-making tech shares.
Going in to 2023 this environment no longer applies. Bonds and cash both offer a respectable return, meaning companies will have to work harder to attract investment into their shares. Indefinite losses and the prospect of making money ‘at some point in the distant future’ is no longer going to cut the mustard.
This is potentially bad news for loss-making companies that suddenly have to try and generate profit and cash to appease shareholders. But it could play into the hands of incumbents, for whom profit and cash has always been a priority.
In this environment, I would expect established retailers like Next*, Primark and Frasers to gain share against smaller loss-making players (some of which – like Made.com – have already gone to the wall). Domino’s Pizza could also benefit as food-delivery competitors – Deliveroo, Uber and Just Eat – retrench from suburban areas, in an attempt to stem losses.
Dangerous debt
Rising interest rates mean debt is becoming more costly. With full employment and a global economy still chugging along, that hasn’t been too much of a problem for most. However, should we go into a deep recession, companies with over-stretched balance sheets could find themselves in real trouble.
In this environment, investors should consider paying a premium for businesses with rock solid balance sheets. Net cash is the ideal position for companies to be in, but modest leverage is fine as long as the debt is appropriately structured. Ideally, look for long-dated, staggered debt maturities, preferably with a large proportion of fixed interest payments; and limited covenants.
Companies that tick this box should be relatively well positioned if the economy does take a turn for the worse. They can maintain investments and perhaps even snap-up cheap acquisitions, leaving them well-placed to steal share from the competition.
Companies with weak balance sheets on the other hand will – at best – find their options limited and at worst may be forced to raise money at an inopportune time, or even go bankrupt.
Pricing power even more critical in 2023
I’ve been impressed this year with the way many companies have passed on price increases, in response to rising costs, without seeing too much disruption. But I think things may become harder.
A robust economy has made it easier for consumers and businesses to accept price increases. But that could easily change in 2023 if higher interest rates and inflation start to strangle the economy.
The other issue is that price increases compound over time. An initial 10% price rise might be palatable, but three such increases in relatively quick succession and you are suddenly faced with prices that are a third higher than before. It means each round of price increases becomes progressively harder, and is accompanied by customers taking an even closer look at whether they can make cutbacks.
Companies that can continue raising prices in this environment without ostracising their customers deserve higher valuations. Particularly if inflation remains elevated.
Moody’s, the credit rating agency, is a good example. The business is cyclical, because it depends on debt issuance, but its customers don’t bat an eye-lid at price increases on a Moody’s debt rating. This is because they are making substantial savings on their debt interest costs by paying Moody’s for a rating.
Luxury businesses like LVMH* also have great pricing power. There is tremendous status and prestige associated with a Louis Vuitton bag, which is only enhanced by a high price tag. This makes it one of the few industries where increasing prices can be met by applause from customers, rather than being tolerated through gritted teeth.
Expect the unexpected
If I’ve learned one thing throughout my career, it is to expect the unexpected.
At the start of 2020, no one predicted a global pandemic. And you would’ve been hard-pushed 18 months ago, when the UK base rate was 0.1%, to foresee today’s double-digit inflation.
So whatever you do, don’t make one-way bets on how the economy or stock market might pan out in 2023.
Try to arrange your affairs so that, whatever happens, you’ll be ok. That means having cash set aside for emergencies, and making sure your portfolio is well-diversified.
When you’re being buffeted from all directions, it pays to make sure your investments aren’t all facing in the same direction.
