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The Great Normalisation

Having worked in financial services industry for 25 years now, I have gained quite a lot of experience and seen several market cycles and periods where different assets and countries have performed better than others, often diverging significantly from one another. I often get asked (particularly after difficult periods of performance): what should I expect to see when things get back to normal?

One of the biggest difficulties in answering this question is understanding what ‘normal’ really looks like. For example, in the 13 years since the global financial crisis, ‘normal’ has largely been interest rates that hover at or around 0%.The 50 years before that saw a normal interest rate of around 5%. So, which one is normal? The reality is that we must get used to whatever the new normal is going to be.

One recent event that was very much not normal was the global pandemic. This event threw so much of the world into disarray and even now, many countries are still finding their feet. Never in history have we had a situation where governments have actively instructed their populations to go home and stop working for the good of the country. During this period of shutdown, governments around the world borrowed (or created) huge amounts of money to ensure that the population could continue to live the lifestyles to which they had become accustomed; think furlough schemes and business support grants and loans. This high level of global government debt has somewhat changed the dynamics of the economy and it is likely that the repercussions of this will be felt (and dealt with) for many years to come.

Taking governments aside (as they are the main parties who now carry the post-pandemic burden), companies have historically been valued as a multiple of their profits. The basic premise of price to earnings ratio is, if I give this company some money now by way of investment, how many years will it take for me to make my money back assuming a constant performance? So, if a company is valued at 10 x earnings, then it should take you 10 years to get your investment back from company earnings. This valuation methodology gives us a benchmark to assess how expensive or cheap a company is at any point in time. Naturally, if a company is growing quickly then one can accept a higher price to earnings ratio today, as the expectation is that profits in the future should be higher and you will therefore get your money back faster.

Over the years – if we look at the world as a closed box – then the value of all investments should roughly equate to the amount of money that people earn, multiplied by the number of people in the population, multiplied by the number of years after which we should expect a return on our funds invested. This calculation is somewhat simplified, but assumes that if you have no money, then your contribution to the economy must be nothing as you cannot buy any goods or services.

Over the years, the value of a country’s stock market should broadly equate to its median income, multiplied by the number of people earning, multiplied by a price multiple. In this respect, we have seen over the longer term that the stock market broadly tracks population and income numbers, rather than some measure of real GDP priced in line with inflation. In nominal terms, the median income in the UK has risen by 28% over the past 10 years (from £27,215 pa to £34,963 pa) and the working population has risen by approximately 7.5% (from 31m to 33.325m). If we assume a static price to earnings ratio of 13.2 x FTSE 100 earnings (December 2014 numbers) then we should expect the value of investments in the UK to be 1.28 x 0.175 x 6608 (the level of the FTSE 100 on Christmas Eve 2014), which equals 9,092.

Looking at this in an alternative way, if we look at inflation alone in the UK from 2014 to 2024 we would see an increase of 33.8% – so inflation alone should have seen the index rise from 6608 to 8841.

With the media reporting that the FTSE 100 is currently reaching record highs, should we therefore be concerned about an impending market crash? In simple terms, it’s unlikely because, based on historic averages, the FTSE 100 (even after the run up to 8,400 in recent weeks) is still significantly undervalued against itself, let alone any other world markets.

If we look at companies in the UK below the FTSE 100, and also consider FTSE 250 stocks, we have seen a rally by 14% in the last six months alone; however, the index is still more than 15% lower than its highs of 2021. Using the same methodology as the FTSE 100 above, we can see that on an identical valuation matrix, the FTSE 250 should be at a level of 22,164 today (i.e., it still needs to be some 7.9% higher than today to get to 2014 inflation adjusted levels) and, if it were to return to its long-term trend, then we might expect the index to go as high as 26,279 (i.e., 28% higher than it is today) before you might consider that it is getting expensive.

What can we take from this? Well, in my opinion, what this all means is that within the UK markets, the recent rally is not really anything spectacular and is more likely a normalisation. We can rally another 8% or so simply playing catch up and the market could go up significantly from there, particularly in smaller stocks outside of the main FTSE 100 index.

So, what are the main factors influencing the current moves in the market and how might this play out in the coming months?

The biggest single factor that will play into the current market rally is almost certainly interest rates; there has been a lot of debate since October 2023 as to when the first interest rate cuts are likely to happen. Between October and December 2023, the markets responded to the Federal Reserve’s comments that interest rates had likely peaked and that the next move would be down.  Whilst the Federal Reserve quoted that their dot plot of likely rate cuts suggested three cuts in 2024, the markets got somewhat ahead of themselves and factored in seven cuts, resulting in a massive rally in US stocks (particularly tech stocks). Since the turn of the year, however, expectations have been pulled in somewhat and, whilst the Federal Reserve has barely budged in their outlook for three cuts in 2024, the markets came all the way in from expecting seven cuts in 2024 to no cuts at all. Over this period, the bond markets have been massively volatile, as have other assets that are seen as bond proxies (such as infrastructure and property), with much of the growth seen over the last three months of the year given up.

In recent weeks, we have seen something of a sea change as inflationary pressures have fallen around the world. One of the main influences for global rate cuts has been the major banks (for example, the European Central Bank and the Bank of England) wrestling with the possibility of frontrunning the Federal Reserve and starting to cut rates before them. This is something of a misnomer; the reality of the situation is that Europe and the UK are experiencing very different financial conditions to those in the US and –  whilst there is a currency risk – if the interest rate differential is too big between competing nations, then we might see a depreciation in Sterling or the Euro and this might mean importing inflation from abroad. In the UK, we trade significantly more with Europe than we do with the US and, as such, we should be more concerned about the value of Sterling against the Euro than the value of Sterling against the US dollar. Therefore, as long as we remain more in lockstep with the ECB, any inflationary pressures should be limited.

We are now in a position where rate cuts around the world are becoming imminent; market expectations are that both the ECB and BOE will start their cutting cycle in June, whilst the Federal Reserve is expected to start cutting rates in September. In the UK, the markets are now expecting three 0.25% cuts this year and a further three next year, bringing the BOE overnight rate to 3.75% by the end of 2025, its current rate of 5.25%. A similar picture is expected in Europe and, whilst the Federal Reserve is currently expected to be slower to join the party, the overall picture is broadly the same, with two cuts this year and four next year.

If we do indeed see the rate cuts expected, then this should be supportive of stocks and very supportive of bonds and other bond proxies, leading to a potential positive correlation of all asset classes for a period (i.e., they will all go up together). Furthermore, if we see a pullback in equity values, then this should be offset by the protective value of bonds, which should continue to perform even in the face of potential recessionary pressures in the future.

At S4 Financial, we are of the opinion that the greatest potential for gains in the next part of the market cycle will come from those assets that are currently valued the lowest; for example, we would expect UK stocks to outperform US stocks, and smaller companies (in the absence of recessionary pressures) to outperform their larger counterparts in the UK, Europe and the US alike.

We also see that a huge amount of money is currently sitting in money market funds and cash, which is quite understandable given that cash has actually paid something notable over the past couple of years (after having paid near to nothing for the previous 10). However, with interest rates coming down, the attractiveness of cash is likely to diminish and even the most cautious investors are likely to deploy some of this cash into higher yielding assets, such as longer term bonds, and other high yielding defensive assets, such as infrastructure.

By way of conclusion, we are of the opinion that, even after the recent rise in portfolio valuations, there is still some way to go just to get back to something of a normalised position, and this should support portfolio values from here on out. There are no guarantees and there is always the potential that something will emerge to derail the current trajectory. The path for interest rates remains volatile and the picture is still somewhat unclear and will likely be very data dependent. The main determinant factor will likely be monthly inflation figures, which – for now, and absent a new shock to the system (such as an escalation of global instability due to war or some other unforeseen shock, e.g., another pandemic.) – appear to be subsiding from their recent elevated levels.

Overall, we remain optimistic that we are at the start of a new growth phase for portfolios, after the period of consolidation that we have seen since late 2021. We have already emerged from shallow recessions both in the UK and Europe and we can see growth accelerating from here. The US remains something of an outlier and, whilst they have avoided a recession so far due to enormous government spending and protectionist policy decisions, their recession may have yet to come. For now, this seems unlikely in the short term, with government spending likely to remain very high up until  – and for some time after – the Presidential Elections.

This article should not be construed as investment advice and you should always seek expert financial advice tailored to your financial situation before making any investment decisions. Investments can go down as well as up, and past performance is not a guarantee of future performance.  

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