December 2022
The Markets
We wrote in last year’s review that the exceptional returns seen in 2021 were not sustainable. Against a backdrop of very low yields in bond markets, lofty valuations in stock markets and risk of policy error by central banks, we warned that returns in 2022 were likely to be much more subdued.
We certainly didn’t anticipate that 2022 would turn out to be so painful for investors in almost all asset classes. Fixed income markets have suffered their worst year since 1788 (we are told) and most equity markets have fallen significantly. Shares of medium and smaller sized companies have been particularly badly hit. In the UK, the underperformance of smaller company shares compared with their larger counterparts is the widest it has been in any recession in the last 50 years. Sectors such as energy have outperformed and companies with the strongest growth prospects have been punished, mainly because their future profit streams are deemed less valuable with higher interest and discount rates.
The rout in bond markets has continued through much of the year and even accelerated in the third quarter as central banks signalled that interest rates would continue to rise until inflation is tamed. The re-pricing of bond markets from the absurdly low yields, caused by years of distortion from negligible interest rates and continuous bond buying by central banks, has been brutal in both speed and scale. However, in the last few weeks, there has finally been some respite for investors in bond markets as signs have emerged that inflation may have peaked, prompting investors to hope that interest rates might not have to rise by as much as previously feared.
The UK gilt market was also sent into a tailspin at the end of September after new Chancellor Kwasi Kwarteng announced a raft of tax cuts which appeared to be unfunded, and which would need to be paid for by yet more government borrowing. The Bank of England was forced to step in to stabilise the gilt market after a meltdown in prices threatened the liquidity of many defined benefit pension funds. Mercifully, the fiscally reckless Truss/Kwarteng partnership was short-lived and the efforts of the new team of Sunak and Hunt to restore fiscal credibility has so far been rewarded with the welcome return of stability in the gilt market.
Global stock market indices have fallen sharply this year, with many down by more than 20% at their low points. The UK stock market has been amongst the most resilient, thanks to its heavy weightings in energy and other multinational companies which benefit from a weak pound. It also has a low weighting in highly valued growth stocks which have suffered most as bond yields have risen.
The US dollar has appreciated significantly against all other major currencies as the US Federal Reserve has raised interest rates more aggressively than other central banks.
With many goods, such as oil, priced in dollars, the strength of the US currency is making the battle against inflation in other countries even harder.
It remains Groundhog Day for daily dealing UK property funds, with the Regulator still yet to make and deliver any decision about the future of the sector. This stems from the obvious mismatch between funds which offer daily dealing and pricing to investors, and the illiquidity and frequency of pricing of the bricks-and-mortar properties in which the funds invest. Both issues could be laid bare if the UK enters a severe recession.
Our Portfolios
Our positioning in fixed income markets has worked well in 2022. We have been underweight in exposure to government debt and this has limited our sensitivity to rising bond yields as prices have fallen. We are very alert to the opportunities that the higher yields now available in bond markets may present. However, there is still significant uncertainty as to the course of inflation and interest rates and so we haven’t yet increased risk at an asset allocation level. Some of our underlying fund managers, though, have started to do so within their portfolios.
In fact, we reduced fixed income exposure in September to fund increased exposure to alternative investments, in which we have enjoyed considerable success in 2022. Whilst fixed income yields are clearly much more tempting than they were at the beginning of the year, there remains clear risk that inflation could prove sticky and will not fall back to the levels that central banks and bond markets are anticipating. This would be especially true if wage pressures continue to build. Investments in alternatives and absolute return funds not only increase diversification in portfolios but also, if well chosen, provide returns that are not dependent on or correlated to rising share and bond prices.
Most of our equity funds have fallen in value this year. Actively managed funds in general, funds with biases to high quality and fast-growing companies and funds which focus on medium-sized and smaller companies have all struggled. Higher interest rates have undermined the valuations of high quality and high growth companies. Medium-sized and smaller companies, many of which are more sensitive to economic conditions than larger businesses, have succumbed to fears of recession. However, we believe it is right to retain our biases to both high quality and smaller companies. High quality companies, with dominant market positions and strong balance sheets, are well-placed to weather economic downturns. In fact, one of the most recent changes in our portfolios was the addition of a fund which has high weightings in companies that sell products that are deemed to be necessities and not luxuries, such as Johnson & Johnson and Microsoft. The path for medium-sized and smaller companies has always been bumpier but the evidence of the higher returns they provide in the long term is irrefutable.
Active managers tend to add most value through recessionary periods as they can avoid low quality and economically cyclical businesses. They can also tactically hold higher levels of cash than passive funds. As the economic clouds darken and if history repeats itself, we should therefore see a return to form for the active fund management community and this would be of significant help to our portfolios.
We care deeply about the performance of our portfolios and have felt much of the pain that equity and bond markets have dispensed this year. Unsurprisingly, we have been continually retesting our investment views and the positioning in our portfolios. However, it is incredibly important at times like this to try and remain free from emotion and not make knee-jerk changes to portfolios by bringing in investments which have recently performed well and ditch those that have not. The latter are likely already discounting a lot of bad news, whilst for the former, it could already be as good as it gets.
Outlook
2022 has been challenging and brutal and we will not be sad to see the back of it. However, we are looking forward to 2023 as we retain high confidence in the outstanding quality of our portfolios’ funds and their management teams. Our portfolios are built for the long term and are characterised by quality companies and attractive valuations.
For those of you who like predictions, here are the Goldman Sachs’ forecasts for the end of 2023:
- GBP/USD: 1.22
- FTSE 100: 7,700
- UK 10-year gilt yield: 4.0%
- UK CPI: 5.6%
- UK core CPI: 3.2%
- S&P 500: 4,000
The months ahead could continue to be volatile. However, the longer term outlook looks much rosier and this is reflected in the long term capital market assumptions which are widely used in the investment industry. For example, the forecast returns (in local currency terms) over the next ten years of J.P. Morgan’s 60% (equity) and 40% (fixed interest) portfolio now stands at more than 7% p.a., having been just 3% a year ago.
Thank you for your continued support. We hope that you enjoy the festive season and have a healthy and prosperous New Year.
Andrew, Charles, Chris, Dan, Mark and Will
The Investment Management Team, Square Mile Investment Services
