Market Update 9th January 2023

Size matters

Copyright and index licences restrict us from naming names, but a well-known index of the UK’s largest companies this morning is, at last, above its pre-pandemic level. Before anyone is tempted to break out the Coronation bunting four months early, its little brother – an index of medium-sized businesses – is more than 10% lower than early 2020, having fallen by 20% over the past year. Big, it appears, has proved to have had an unexpected allure.

I had to rewrite the previous sentence. I initially typed that Big “is proving to have” this unexpected allure. In so doing, I was falling into one of the most slippery and dangerous traps in investment. Psychologists are wont to refer to this as ‘recency bias’. This is the tendency to take what has most recently happened and to extrapolate that into a prediction that it will continue to do so. The fact that the largest companies in the UK fared significantly better than medium-sized businesses does not mean that they will continue to do so in 2023.

At some point in the last few days (I regret that I remember neither when, nor from whom the sagely advice came) I read a short piece by a fund manager who argued that the best thing that happened in his career was when he was made to rip up his existing portfolio and start again. It provided said manager the opportunity to ditch both his baggage and his sacred cows. It is an extreme example, but it makes the point. 2022 was a year that was very good for oil companies, for miners and for overseas earners. It should be a statement of the very obvious that 2022’s performances have no bearing on what we should expect in 2023.

2022 was a weird year. I should say, yet another weird year. The global economy struggled with its ongoing post-pandemic adjustments, a war in Europe, berserk energy prices and China’s covid lockdowns. This is not even to mention double-digit inflation and a huge increase in the cost of borrowing. And even then, we have to throw a year in which the only thing missing from Downing Street was a trouserless Brian Rix. A high oil price and a run on the pound made for very good trading conditions for a select few. For the majority of the rest – as shown by the performance of the mid-cap index – 2022 was ghastly. Inflation clobbered margins, whilst labour was a painfully short commodity.

2023 is different. Brent crude oil was $120/bbl, it is now around $80. European natural gas was €340/mwh, it is now €70. Sterling was less than US$1.10, this morning it is over $1.20. Those tailwinds, unlike the stream of Atlantic depressions coming over Cornwall, look to have run out of puff. Last week we saw a great deal of economic data relating to the end of last year. In many ways it is highly encouraging. Or it is at least in terms of the likelihood of a fall in inflation. Manufacturers’ order backlogs are decreasing rapidly. Freight rates have, at last, begun to fall. The tightening of monetary policy has started to kick in. And this, as far as financial markets are concerned, is good news.

That much is relatively straight forward. The tricky part is what damage has already been done to companies’ profits and what is yet to come. In this regard, the next month will be crucial. The US earnings season gets underway this week, with Friday being especially busy. As is usual, we start with the profits of the banks, which will be a balancing act between their need to raise provisions and the boost to margins from higher interest rates. According to FactSet (now the definitive source of earnings estimates), the US market as a whole is expected to have shown earnings growth of 5.1% in 2022. This though, is pretty much wholly attributable to the oil companies. Without these, earnings would have fallen by close to 2%.

For 2023, the overall expectation is broadly the same: earnings are expected to grow by 4.8%. This, though, is a recipe of a fall in the profits of the oil stocks, offset by a surge in ‘consumer discretionary’ businesses (the likes of Apple, Nike, Amazon.com, Walmart and Tesla). Just as the UK benefited from exchange rates last year, so a large rise in the dollar hurt US business. A weaker dollar would be very good for the US, for Emerging Markets, and for domestic businesses everywhere outside the US.

Jim Wood-Smith – Market Commentator and Head of Climate Transition

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