James Gard: Welcome to Morningstar. With me today is Michael Field. He is our European Market Strategist. Thanks for joining me today, Michael.
So, every month we get together and we try and discuss the salient points in the market, what’s been going on, but this is the last conversation of the year. So, we’re also going to look ahead to 2024. I’m also excited to talk to you today because we’ve had three central bank decisions back-to-back, and the markets are on the move today. So, there’s a lot to think about at the moment. Should we start with this year and then move on to 2024 after that?
Michael Field: Absolutely. So, obviously, 2023 has been a really eventful year and not only just for good reasons. We started out the year thinking that we were going to be on this kind of structural upswing after the pandemic, China reopening, a lot of positive catalysts to look forward to. And then of course, we had the banking crisis in March and then things continued on from there really, markets rallying and then waning over the course of the year. But thankfully, and like you said, today is a really interesting day.
You have a lot of excitement from the Fed’s decision last night and the minutes around the Fed meeting, which I actually thought were pretty benign. I didn’t think they said anything in particular that gave us this great hope, but the market seems to have just latched onto it. And you see markets rallying today. And if you look at where we are, the S&P 500, the Euro stocks, the FTSE, it doesn’t really matter which of those three you look at, they’re all really close to all-time highs, which given that we’re not out of the woods yet that we’re still – European economies are still teetering on the brink of recession, it seems quite crazy. But there you go.
Gard: Sure. Yeah, making notes to talk to you today, I’d written “against the odds” as my headline for European markets this year. And despite obviously two downturns during the year, European markets or indices certainly have done pretty well considering. And I’m leaving out the U.K. here and I’ll maybe circle back to that. But yeah, so I think if you look at European indices, it’s been a really good year for investors.
Field: Yeah, indeed. I think against all odds, I think you might have stolen that from a love ballad. But there you go. Yeah, it’s been a pretty – like all-in-all for investors when you wrap up how much they’ve gained over the course of the year, it’s been positive. Again, whether you’ve invested in the U.S. or indeed Europe, the returns have been double-digit. Surprisingly enough, I think if you had told me that a couple of months ago, I probably wouldn’t believe you. So, generally speaking, it’s been a decent year for investors. And then, on the back of that then things should be improving over the course of 2024, at least in terms of interest rate decreases as well. So, as much as I pointed out, that it seems crazy that markets are close to all-time highs, you can certainly understand why investors are confident given the returns that were generated for them in 2023.
Gard: Sure. So, I mean, the conditions look good for the end of the year rally continuing to next year. But just to stick with the U.K. a little bit, the U.K. doesn’t seem to have participated. If you look at the FTSE 100, it’s the same as it was effectively at the beginning of the year, give or take a few moves up and down. Why do you think the U.K. has been left behind really in the global rally?
Field: So, I think the first thing to say is that, yes, it hasn’t seen the same gains as other indices year-to-date, certainly. But your point that it’s similar to where it was at the very start of the year somewhat ignores the fact that that’s still very close to all-time highs as well. So, in terms of the movement it had or the scope it had to move, it hasn’t done that badly all in all.
But there is some truth to that, of course, right, why it missed out. I think structurally the FTSE 100 has some issues. And I think investors are very much picked up on this. And this is the trends we’re seeing in terms of equity outflows from U.K. indices, which have been negative for every single month this year by January. So, I think you’re getting this rebalancing of global portfolios. And the U.K. main indices are just less attractive at the moment. It’s primarily stuffed with banks and natural resource firms. So, there’s very little growth industries. It’s been well documented and more companies this year shifting their main listing to the New York Stock Index instead. So, I don’t know how much more we can add on that necessarily, but I think that is one of the primary drivers why the FTSE has been left out to some degree.
Gard: Sure. I mean, every year I read outlooks from banks, asset managers saying the U.K. is very cheap and this next year will be a great year because it’s a great buying opportunity. I mean, I’ve read it so many times that I mean, eventually it might come true. But yeah, don’t expect great things of the FTSE per se. But if global markets do well, then the U.K. should sort of get a little bit of a boost from that?
Field: Yeah, I think that’s fair. And look, you mentioned it yourself, but if you look at, for example, the P/E of the FTSE 100 relative to the S&P 500, it’s trading at something like half the P/E. So, I think the lesser growth profile of some of the companies that’s contained in that and the rather dull expectations around performance are priced in if you look at something of a P/E for sure.
Gard: Sure. Yeah. Well, who knows really. So, thinking ahead now to 2024, this is kind of the exciting bit. But just looking at your recent outlook piece, you think inflation is going to stick around, but the West should avoid a recession. So, things look teed up for a relatively decent year.
Field: I think that’s fair to say overall. Interest rates are set to come down across the Western world as the three central banks primarily that we’re looking at. So, that’s certainly a positive anyway for equities. That sets up the story quite well for next year. Valuations on the whole, they’re close to fair value. If we look at the European market as a whole, it is close to fair value. But within that, there’s plenty of gaps and there’s plenty of unloved areas of equities that investors can jump aboard on. And one such one that I think you saw online today on Twitter, I put a tweet about it earlier was the utilities sector that’s been very much beaten up both in the U.S. and Europe and is offering really steep discounts at this stage. And investors seem to have ignored certain features about that industry and the fact that they’re buying stocks that are growing and dividends that are growing rather than just a fixed income stream as they are with bonds. So, it’s not a like-for-like swap, which is what some investors have done over the last six months when they’ve exited. So, I think, yes, there’s definitely certain industries that are set to benefit.
I think overall, yes, 2024 is kind of teed up to be a better year in some respects. But what I would caution on the back of that too is that we’re looking at – still in the U.K. and in Europe, we’re looking at the highest interest rates we’ve had in 16 years now. They’ve only been that high for six months or so. So, we haven’t seen the full effects of really high interest rates feed through to the economy just yet. It’s starting to. You’re looking at mortgage applications in the U.K. or mortgage approvals are at their lowest rate now in over a decade. So, they’ve fallen 40% year-over-year. A lot of that negativity is coming through right now. But the dangerous part I think for businesses and consumers alike is that there’s more of that pain to feed through in early 2024. So, I think for investors, yes, there’s opportunity. Yes, when those interest rates fall, it will benefit these companies. But don’t be shocked if the first few months or even the first half of 2024, you still read negative statements from companies and you still see some of that negativity coming through because we’re primed for it.
Gard: Sure. Yeah. I mean, we’ll pick up on sort of earning season predictions a little bit later. A lot of people are remortgaging or moving on to new rates next year. So, there will be no doubt a lag for some economic sectors, more cyclical or exposed sectors. The U.K. retail has been reasonably resilient. But the prospects aren’t amazing for next year, let’s be honest.
Field: I think that’s fair. Yeah. And it’s one of those discretionary areas of consumer spending that people can cut back on quite easily, not buying that winter jacket that they wanted. For most people it’s very possible. And I think compared to – we’ve all seen our heating bills and things like this – I got a shock this morning seeing mine. So, yeah, I think the consumer has been hit on very many sides, and something like retail is something that they can easily cut back on. I think I read some stat recently showing how much excess clothing and excess items the average U.K. household has. So, it’s something that could feel pain for the next six months. But on top of that, you’re seeing other elements as well. I saw some stats. And this is slightly peripheral, but shoplifting is at ultra-high levels across the U.K. and Ireland in the last six months. So, I think, that’s very indicative as well of just how many people are really, really struggling. So, I think yet indeed, you’re right, we could see some pain for quite a while. So, I think, to some degree, some of it’s incorporated into valuations already. But I think the picture is really, really mixed across the consumer sector.
Gard: Yeah. In your notes, you said that you can’t see an obvious catalyst for consumer cyclicals rebounding, even though they look cheap.
Field: I think that’s fair. And you’ve seen some sectors of the consumer segment, as in travel, for instance, that picked up massively.
Gard: Yeah.
Field: I think one of the problems here is the fact that if you look at the number of hotels and restaurants available, it’s still below pandemic levels, whereas demand is back to pandemic levels, which has caused that imbalance that we see when we go to a restaurant, and they’re all full, right? And we’re wondering what’s going on in consumer land, have suddenly people got way more money than they had before, which isn’t the case. So, I think those elements of consumer discretionary spending are caught up fully, and that should grow at a normal rate from here. So, there’s no real catalyst there.
And then, in luxury, for instance, was one we were touting as well for a while as really defensive, marketing themselves more towards the higher-income consumer, who is less susceptible to not getting wage increases, it doesn’t matter as much to them. So, that was a sector we touted for a while as bulletproof to some degree, but the cracks are starting to show there now. You’re seeing a lot of luxury manufacturers talking having about large unsold inventories and having to mark down goods and things like this as well. So, that’s another segment of consumer that’s struggling a little bit now. So, I think, yeah, look, there’s obviously exceptions to the rule, but for the most part in consumer land, the average consumer only has so much money to spend. Heating bills are still high, utility bills are still high. And for the most part, like you mentioned earlier, a lot of them are rolling off from variable mortgages, and their monthly payments for housing are going up. So, something has to give, you know.
Gard: Sure. Yeah. I used to think it was a case of kind of haves and the have-nots in terms of the wealthy can still travel and like you said, the rest are cutting back significantly. But I think, there’s a lot of people struggling, and that’s not going to change dramatically next year. So, moving on a little bit from consumer, you’ve taken bit of a defensive bent for your sector outlook for next year. I’ve got a slide here and you’re looking at, at the moment, healthcare and utilities. You mentioned utilities already. With healthcare, it’s quite an interesting sector. It’s usually a defensive sector. In the U.K., Glaxo shares haven’t done particularly well this year, but say, Novo Nordisk had an amazing year. I know they had a breakthrough with one of their diabetes drugs, I think it was. What would be your picks in terms of within that healthcare sector? I think you mentioned oncology and innovation.
Field: Yeah. I think the first thing to touch on there is the focus on the defensive sectors. It’s not that we’re saying they’re the only sectors you can invest in. What we’re saying is if you look at the picture – and this is not only on European basis, but a global basis – if you look at the investment picture currently and which sectors are screening up as good value, there’s quite a bit of options. You have consumer cyclicals, which is one of the cheapest sectors still at the moment, communications, financials, for instance, all of these are screening super cheap. But some of them are cheap for a reason, that there’s a large investor concern over some of these really highly exposed cyclical stocks. And yes, we think things are picking up to some degree in 2024. The interest rates cuts when it feeds through will be a positive catalyst. But in the meantime, if you look at the economies of the U.K. and Europe, they’re still teetering on recession. The U.K. had a pretty decent GDP reading the other day. But by decent, I mean, it was up 30 basis points month-on-month, which isn’t something to necessarily pop the champagne open about. And then Europe, again, you’ve got negative readings in Europe at the moment.
So, I think economies are teetering around recession. Investors are aware of this. So, that’s why they’ve applied this pretty sizable discount to the cyclical sector, because they know that there’s a danger if they invested in some of these really cyclically exposed stocks. And we go into a recession that they’re going to feel pain before things eventually come right. And they’re very much aware of that. So, what we’re pointing out is something of a counterbalance and a midway point is the more defensive sectors like pharmaceuticals, which we mentioned, and then utility sectors as well, something that offers you a little bit of protection, if indeed we hit a bump in the road, and the economic situation gets worse before it gets better. So, we mentioned utilities and people are very much, I think, aware of the defensive qualities of utilities and the predictability of their revenue streams. We all have to play bills, and that’s where that money ends up at the end of the day.
Pharmaceuticals, obviously, another very much defensive industry. Usually, this is one that I don’t really highlight, because it’s usually fully priced. People are very much aware of the defensive qualities of the industry, and people are very much aware of the growth profile of the industry as well, and they think it’s worth a premium. Not this time around. I think what’s happened this year is you have a number of fears. So, a lot of these companies – and you saw Pfizer had a release the other day, and they’re struggling with COVID drugs. Basically, sales aren’t coming in as expected from COVID-based drugs, which is one of investors’ concerns. So, it seems like investors have been rightly concerned when it comes to areas like this that they thought these drugs might disappoint this year. And they seemingly are right. We took down our fair value estimate of Pfizer slightly the other day. We still see a lot of value with that name. But we took the fair value estimate down slightly.
But in other areas, like you said as well, immunology, oncology, et cetera, those are the areas where we see the growth profile really strong over the next few years. And investors, one of the other concerns they have is around the patent cliffs and whether the growth pattern is good enough to make up for that patent cliff shortfall that’s going to happen over the next few years. And this is the discount they’re placing on the stocks. But again, you see areas of breakthrough all the time. And you mentioned Novo Nordisk. And then that comes around with the weight loss drugs, essentially. And the market is getting a little bit excited about weight loss drugs. But the flipside is that is they’re very much ignoring the oncology and the immunology drugs that I mentioned a couple of seconds ago. So, there’s definitely areas of the pharma sector now that are presenting themselves as opportunities, and very much defensive opportunities, which again, I mentioned, is the sweet spot going into 2024 with all the uncertainty that we’re facing.
Gard: Great. Yeah, that’s certainly a compelling case for looking at that sector. Just looking at next year, things that could blow up, basically. No one really foresaw the – I won’t call it a banking crisis, but it was certainly a banking storm in March. Are things okay there? And would you add, say, commercial property into the things that could just really surprise to the downside next year? I’ve given you two questions, basically – but are banks going to explode again? And is there going to be some sort of reckoning for the commercial real estate sector?
Field: I think the answer for both is no in that none of them are going to blow up. I’m trying to remember exactly how you phrased the first question. No, banks indeed, so everyone had a panic March this year. It feels like about two years ago at this stage, but it was only March this year. And we thought that there was going to be this domino effect across Europe and the U.S. with banks blowing up. And after the Credit Swiss debacle, nothing really happened. And then, our analysis at the time pointed out that European banks were pretty well capitalized. And that’s still the situation we stand by and the analysis we stand by as well. I saw a chart recently done by one of our banking analysts looking at the largest banks across Europe. And if you actually look at the capital buffer for each of these banks, it’s sizable. So, all these banks are pretty well capitalized.
That’s not to say that nothing can happen. Banks as part of their business model rely to a heavy degree on leverage. So, that’s always a risk. But from a capital perspective, they’re as well capitalized as they possibly could be. So, there shouldn’t be another banking crisis on that basis. In saying that – and this is our slightly contrarian view on banks, which I’m going to throw into the mix here as well – up to now, we’ve been saying, okay, banks are kind of a gimme. Their valuations have been hammered; you should be buying them. But what we’ve been saying since about the third quarter of this year is that a lot of them have run up. Not all of them, we still see some opportunities, but banks have run up to some degree. And within that now, the returns on capital that they’re actually producing are probably at their peak, that what you could see from here – the big benefit there was that net interest margin expanding. So, the difference between what they’re lending out and what they’re borrowing at was finally getting to a decent level, and they could start making some proper money, which they did.
But the problem from here is where do they go? Like you’re having – I mentioned mortgage approvals are 40% down year-on-year in the U.K. So, that’s something that’s happening. That’s negative for them. And you should expect bad debts and the bad loan book to increase from here as well. We think it will be manageable, but at the same time, that’s a weight on profitability over the next six months, maybe a year as well. So, from that perspective, some banks are looking attractive, but the overall picture isn’t the sunny uplit lands that we talked about earlier this year.
Gard: Sure. The best may be over in terms of the banks, because if rates are probably peaked, possibly certainly in the U.S. and Europe, it’s not going to get any better in terms of net interest margin.
Field: That seems to be the case, James. Looking at the Bank of England statements today, they’re still threatening that they could move up rates. But I think this is less believable at this stage. I think they’re just giving themselves room for manoeuvre in case something untoward happens that they might have to, and they don’t want to shock the market. So, they throw all of this in the mix now to say, well, we told you back in December.
Your second question about risks to the to the economy. Commercial property, yeah, in the outlook document we produced here, we mentioned commercial property as one of the risks. To some degree, I think the market has got a reasonable handle on what’s happening with the return to office, which types of commercial property are being used and which ones are struggling. But there is a lag like you mentioned with other sectors earlier, and that’s still feeding its way through the economy as leases expire and things like this as well. So, I think, the sector itself could be in for something of a reckoning in 2024. But will the ramifications that extend to the wider economy? It’s less likely, I would say, at this point, at least anyway. There’s many other left field risks we discussed, or I can probably pull out as well to the market, generally speaking. The Chinese economy number one as well, and property – the property market there Evergrande, we’ve been reading about that for quite some time now and defaults around that. So, I think there’s plenty of risks and then outside risks as well, like the risk of Taiwan being invaded and knock-on effect with semiconductors. But I think at this point, then, we’re getting into those kind of real tail risks.
Gard: That’s the sort of risk that we were expecting this year to come to fruition but may well become another risk next year. But again, hopefully, it won’t be. But it’s in sight. It’s not going to surprise anyone if it does happen. Thinking just to sort of wrap up really, I mean, we got two potentially U.K. and U.S. election next year. Do they have the potential to introduce some volatility into the market and disrupt the higher market narrative that we’re anticipating at this point?
Field: So, I think, the U.K. election probably less so. I think if you look at the manifestos of Labour and the Conservatives at this point, aside from that kind of awful autumn statement that we got back in 2022, there was nothing really that shocked the bond markets. So, I don’t think necessarily that a surprise in the U.K. election. And look, Labour have been, what, 20, 25 percentage points ahead now for quite some time in the polls. So, I think to a large degree, the markets are very much aware of the U.K. political situation.
The U.S. political situation is a bit more volatile, shall we say, because we don’t know exactly what kind of policies Trump would bring in if indeed he returns to power for another four years. And from what I’ve been reading recently, the ramifications for the rest of the world could be huge this time, particularly given that the world is in a pretty precarious place with the Ukraine and Russia conflict, that any change to funding and support in that could lead to much bigger ramifications for Europe in particular. So, there’s so many knock-on things that could happen from there that I don’t think they’ve been fully analysed and that that will certainly shock the market. But not necessarily if he gets elected, it’s more kind of what policies come around after that, and there could be a series of shocks, I think, we could be start to worrying about at some point.
But – and this kind of ties it together really, I think – but one of the positives coming out of the pandemic and the Ukraine war is that the market hadn’t really focused on these tail risks as much as it should have over the last few years. But I think even from looking at that outlook document now, I feel like we as an organization as investors are way more aware of the potential risks. And we’ve already started to name them and talk about the ramifications of them already. So, I think just that awareness alone is a very positive sign for markets that at least they’re thinking about these risks ahead of time and should be less surprised if indeed one or more of these actual events happen.
Gard: Sure. Yeah. I mean, forewarned is forearmed, and I think investors in the past have previously been blindsided by things that maybe were likely to happen. So, the geopolitical risk is always with us. It seems to be priced in very quickly with markets and markets tend to move on very quickly unless things get extremely bad geopolitically. But it’s always worth starting in the thinking what potentially could go wrong rather than what’s likely to go right.
Field: Absolutely.
Gard: Great. Well, thanks so much for your time today, Michael. Look forward to catching up in the new year and we’ll be talking about earning season where all the world’s biggest companies will say how well they’ve done in 2023. So, look forward to catching up with you then.
For Morningstar, I’ve been James Gard.
