Summary
After rising relentlessly throughout the year, headline rates of inflation in the UK and Europe finally dipped in November, although they remain cripplingly high. We expect inflation to continue to subside in the months ahead but more important is where it settles in the medium term. What began as inflation in prices of energy and manufactured goods has now clearly spread to services and to wages in particular. Rising interest rates will take a toll on economic growth and rising unemployment may be the best way to curb inflation in wages. We therefore expect the focus of attention amongst investors to shift from inflation to economic growth in 2023. There are clear risks to the consensus that any recessions will be mild, that inflation has been conquered and that interest rates will soon be on the way down.
2022 was truly an ‘annus horribilis’ for investors in bond markets. For more than a decade before, investors had enjoyed outsized returns from bonds as quantitative easing and negligible interest rates compressed bond yields to levels which became simply absurd. The return with a vengeance of inflation has erased those past excess returns in the most brutal manner. The big decision for investors now is whether they should be increasing their exposure to bonds. Yields on offer are certainly much more attractive than they have been for years. However, they are still significantly lower than where they averaged in the decade before the distortion of quantitative easing began in the wake of 2008’s financial crisis and when inflation was also much lower than it is now. Although acknowledging that pockets of opportunity now exist, such as in high quality sterling corporate bonds, we do not yet think that the case for increasing our overall exposure to bonds is compelling.
Despite a spirited rally in the final quarter, global equity market indices ended the year down by just over 15% in local currency terms, making 2022 the worst year for stock markets since 2008. The declines in stock markets last year were mainly due to falling share valuations as interest rates and bond yields rose. In 2023 we expect corporate profits to become the main driver of share price performance. Economic growth is measured in real (i.e. after inflation) terms so it is quite possible for corporate profits, which are reported in cash or nominal terms, to grow in a recession. Control of wage inflation will be critical in protecting profit margins and companies with dominant market positions and strong balance sheets will be best placed to weather any forthcoming economic storm. We continue to emphasise those characteristics in our fund selection in actively managed portfolios.
Macro Highlights
2022 will be remembered as the year when inflation erupted again after years lying dormant. In the UK, the annual rate of inflation, as measured by the Consumer Prices Index (CPI), dipped to 10.7% in November from a 41-year high of 11.1% in October. Similarly, the inflation rate as measured by the ‘old’ Retail Prices Index, which many would consider a truer measure of the cost-of-living as it includes mortgage interest payments and is the basis for price increases for many services such as mobile phone tariffs, eased slightly from 14.2% to 14.0%. The same pattern was seen in Germany where the inflation rate improved from 10.4% in October to 10.0% in November and again to 8.6% in December. However, this will hardly be a cause of celebration in a country where the scars from the hyperinflation suffered in the Weimar Republic almost exactly 100 years ago are forever etched into the German psyche, making the control of inflation a national obsession. In the US, the headline inflation rate peaked at 9.1% in June and has since fallen steadily to 7.1%. The main reason why the trend in inflation has been better in the US is greater self-sufficiency in energy supplies.
It was, of course, almost a mathematical certainty that rates of inflation would retreat from their peaks. This is because inflation is a rolling one-year measure so the steep increases in prices due to supply bottlenecks, surging energy prices and shipping rates in late 2021 are now beginning to drop out of the calculation. Indeed, it is mathematically feasible that headline rates of inflation could even briefly turn negative at some stage over the next twelve months, although this would probably require both an end to the conflict in Ukraine and to sanctions against Russia. The latter, which could cause gas prices to plummet, seems highly unlikely in the absence of regime change. As we have written before though, falls in headline rates of inflation, although welcome, are less important than where ‘core’ inflation settles in the medium term. The inflation we are experiencing began in the prices of energy and manufactured goods. However, it has now clearly spread to services and to wages in particular. A falling rate of inflation does not, of course, mean that prices are falling. It just means that prices are rising less fast. Wages have not kept pace with price rises that are already baked in and this, together with the jump in mortgage interest rates, is the root cause of the ferocious squeeze in the cost-of-living being suffered by consumers.
Unemployment rates, though, remain close to 50-year lows in both the US and the UK. Workforces have shrunk as populations have aged. In addition, legions of workers have been able to take early retirement because of the extraordinary inflation in asset prices fuelled by more than a decade of quantitative easing and negligible interest rates. As a result, labour markets remain very tight, with the number of job vacancies exceeding the number of those seeking work. It is therefore no surprise that wages are now rising by more than 5% p.a. in the US and by more than 6% p.a. in the UK. Indeed, demands for double-digit wage increases in the UK’s public sector now seem to be the norm. This is the inflationary pressure point we are watching most closely as, absent an improvement in productivity, this is what sustains a wage price spiral.
Despite this, we expect the main focus of attention amongst investors in 2023 to shift from inflation to economic growth. The principal therapy being administered by central banks to tame inflation is higher interest rates but its side effects will inevitably take a toll on economic growth. Unpalatable as it may sound, central banks need unemployment rates to rise as this is the best way to curb wage inflation. The only way to achieve this is to cause economic growth to slow. In the US, interest rates were raised seven times during 2022 from 0.25% to 4.5%. However, consumer spending, which accounts for almost 70% of the economy, has so far remained resilient. In the UK, the Bank of England’s base rate started the year at 0.25% and was increased eight times to 3.5%. With both the US Federal Reserve and the Bank of England deciding to increase rates by smaller amounts in December than in previous months, the consensus is that an end to this cycle of interest rate hikes is in sight. In the UK interest rates are now expected to peak at 4.25% or 4.5% in the first half of 2023. This is much lower than projections in the immediate wake of Kwasi Kwarteng’s disastrous mini-budget at the end of September. In the US, interest rates are forecasted to peak at 5.25%.
At the same time, it is widely believed that any recession in the US will be both short and mild. In the UK, investors also seem remarkably sanguine about forecasts from both the Bank of England and the Office for Budget Responsibility that the economy will remain in recession until 2024. It is possible, however, that those recessions will be worse than expected, that inflation (and core or wage inflation in particular) will prove sticky and that higher interest rates will therefore be needed for longer. Whilst we are not predicting these outcomes, it does seem to us that the current consensus could prove to be a bit too optimistic. As always, we will continue to analyse the data methodically and be willing to adjust our investment strategies accordingly.
Bonds
2022 was simply a horror show for investors in bond markets. No-one should be surprised. For more than a decade before, bond markets were distorted by almost continuous bond buying by central banks (quantitative easing) and negligible interest rates. These policies led to outsized returns for investors in bonds as yields were compressed to levels which were clearly absurd. As a reminder, when the price of a bond rises, its yield (which is derived from interest payments that are fixed) falls. Just two years ago, investors in 10-year gilts were receiving a paltry return of just 0.1% p.a. to lend to the UK government for ten years. Investors in German government bonds were actually paying 0.8% p.a. for the privilege of lending to the German government for ten years. All that was needed to jolt investors back to their senses was a catalyst and that duly appeared in the return of inflation. Initially dismissing rising inflation as transitory due to the ending of COVID restrictions, central banks have spent 2022 scrambling to catch up by raising interest rates as inflation has spread and infected almost all parts of the global economy.
The performance numbers for bond markets in 2022 make truly gruesome reading. In the UK, yields on 10-year gilts began the year at just under 1% and ended 2022 at 3.7%. For an investor tracking the conventional (as opposed to index-linked) gilt market as a whole, this translated into a loss of nearly 24%. In the immediate wake of the Kwarteng mini-budget at the end of September the year-to-date loss was even bigger at just over 30% as 10-year gilt yields soared briefly to 4.5%. This prompted the Bank of England to intervene to avert a crisis in a hitherto obscure part of the UK pension fund market. The subsequent U-turn in fiscal policy from free-spending to austere under new Chancellor Jeremy Hunt caused yields to tumble to just over 3% by late November (and year-to-date losses to contract to 19%) but it is interesting and more than a little worrying that yields resumed their ascent in December. In the US, 10-year Treasury Bond yields started the year at 1.5% and ended it at 3.8%. In Germany the equivalent figures were negative (0.2)% and 2.5%, the latter the highest since 2011. However, losses for investors in the US and German bond markets were significantly smaller than for investors in gilts. This is because the repayment profile of the gilt market is much longer-dated than other government bond markets, making returns much more sensitive to changes in yields.
The same factor was evident in the index-linked gilt market. With inflation raging you might think that index-linked gilts, with both interest and capital repayments linked to inflation, were a great investment in 2022. Quite the opposite. The maturity profile of the index-linked gilt market is even longer-dated than the conventional gilt market so index-linked gilts are even more sensitive to rising yields. In addition, the price of an index-linked gilt reflects anticipated inflation over the lifetime of that gilt rather than just the current rate of inflation and, perhaps surprisingly, expectations of long-term inflation changed very little during 2022. An investor tracking the performance of the index-linked gilt market as a whole therefore lost approximately 33% in 2022. The price of the longest-dated index-linked gilt in issue (maturing in 2073) fell by more than 70% during the year.
The big question, though, is whether investors should be increasing exposure to conventional bonds after the big rises in yields in 2022. Unsurprisingly, there is no shortage of champions of such a strategy, although to proclaim current yields as a once-in-a-lifetime buying opportunity seems excessive. 10-year UK and US government bonds, offering yields in excess of 3.5% are certainly much more appealing as investments than they were twelve months ago. However, those same yields averaged more than 5% in the decade leading up to 2008’s financial crisis when rates of inflation were considerably lower than they are now and the distortion of bond markets by quantitative easing was yet to begin. There is a danger, therefore, that the reset and move to higher bond yields is not yet complete and that interest payments could be erased by further capital losses. At the back of our minds, we also continue to be troubled by spiralling levels of government indebtedness. In 2006, the UK’s debt to GDP ratio stood at 40%. It is now more than 100% and heading higher, not least because approximately one quarter of the UK’s debt pile is index-linked. The interest on that debt in the current fiscal year will more than double to £120bn, more than the budget of any government department apart from Health. In the US, the debt to GDP ratio has increased from 65% in 2006 to almost 140%. Some commentators dismiss these ratios as unimportant. After all, Japan’s debt to GDP ratio is more than 250% and Japanese 10-year government bonds yield less than 0.5%!
Whilst accepting that government bond markets are much more attractive than they were, we do not yet believe that the case to increase our overall exposure to bonds is compelling. Pockets of value are emerging, such as in short-dated, high quality, sterling corporate bonds in which yields as high as 6% can now be found. We are therefore considering some changes to the existing mixes of bond funds in portfolios. There may also be opportunities to profit from the continuing volatility in the outlooks for inflation and interest rates but the best way to capture these in portfolios which use actively managed funds is through our allocations to strategic and flexible bond funds.
Equities
Taking its lead from bond markets, the impressive rally in stock markets during October and November faded disappointingly in December. Despite this, global stock market indices still delivered a very healthy gain of more than 7% (including dividends) in the final quarter of 2022. For the whole of the year, however, global stocks were down by just over 15% in local currency terms. This made it the worst year for stock markets since 2008 when markets fell by 38%. Whilst 2022 was an unfamiliar and distressing experience for many investors, global stock market indices have still returned 20% over the last three years (6.2% p.a.), 42% over the last five years (7.2% p.a.) and a staggering 167% (10.3% p.a.) over the last ten years. We remind readers again that equities are long-term investments and periodic losses go hand in hand with the superior returns that equities have delivered over time.
The declines in stock markets in 2022 were predominantly due to falling share valuations. Although the pace slowed dramatically from 2021’s COVID rebound year, corporate profits generally continued to grow. The ownership of a share entitles the holder to a pro-rate share of the profits of a company. The price of that share should represent the net present value of its future profits stream. As interest and bond yields have risen, however, the value today of profits arising in the future is lower because a higher discount rate needs to be applied. It is therefore no surprise that companies which are projected to deliver the biggest increases in profits in the future, so-called ‘growth’ stocks, have seen the biggest declines in share prices as their valuations have tumbled. This also explains some of the most glaring differences in regional stock market performance. At the end of 2021 almost 30% of the US’s main stock market’s index was accounted for by technology companies. Indeed, the five biggest companies in the US were: Apple, Microsoft, Amazon, Alphabet (Google) and Tesla. In 2022 the share prices of these fast-growing companies fell by 27%, 29%, 50%, 40% and 65% respectively. Overall, the main US stock market index fell by 19% in dollar terms over the year. Losses for sterling-based investors, however, were reduced to 8% because the US currency appreciated by over 12% against the pound.
In contrast, the UK stock market stood alone amongst major stock markets in delivering a positive total return of +0.3% including dividends in 2022. The power of dividends as an important contributor to total return is often overlooked by investors and without them the UK stock market would have fallen by (3.2)% in 2022. The very strong relative performance of the UK stock market is because its composition is dramatically different to that of the US. The UK has virtually no large technology companies and instead the biggest constituents of its stock market indices include oil companies (BP & Shell), mining companies (Rio Tinto & Anglo American) and banks (HSBC). There was much less scope for the valuations of these companies to compress because they were low already. Just two of the UK’s ten largest companies (healthcare companies AstraZeneca and GlaxoSmithKline) can perhaps be reasonably described as ‘growth’ companies. The largest companies in the UK are also almost all multinational companies which generate a high proportion of their revenues and profits outside the UK. They therefore benefited from the weakness of the pound in 2022. The largest companies apart, other UK shares performed in line with their peers, with indices recording the returns of medium-sized and smaller companies falling by 18% and 17% respectively in 2022. Equities are long-term investments but investments in medium-sized and smaller companies even more so. The exposure in our portfolios to medium-sized and smaller companies last year was painful but history gives us confidence that our perseverance will be rewarded in the long run.
Looking ahead, the prospect of recession in 2023 would not appear to be a conducive backdrop for stock markets. However, economic growth is measured in real (i.e. inflation-adjusted) terms. If an economy grows by 4% in nominal or cash terms but inflation is running at 6% then it is technically a recession. Corporate profits, though, are measured and reported in cash terms so it is perfectly possible that they can grow in a recession. For many companies, a moderate level of inflation is actually helpful! Corporate profits are, of course, calculated by subtracting costs from revenues. Companies with dominant market positions and strong pricing power should be able to continue to grow their top-line revenues. Other companies which are more exposed to the cost-of-living squeeze will struggle to do this. The cost side of the equation will perhaps be even more important. Some costs, such as energy-related ones, are hard to control. For most companies, though, wages are the biggest expense and this is why control of wage inflation is critical in protecting corporate profit margins. Falling revenues, spiralling wages and higher borrowing costs will prove a toxic mix for many companies in the year ahead.
We therefore believe that there will be considerable divergence in share price performance in 2023. In portfolios which use actively managed funds, we are therefore continuing to emphasise exposure to high quality companies with dominant positions and strong balance sheets. More than ten years of quantitative easing and negligible interest rates created a flood of cheap liquidity which lifted all boats and created considerable froth in financial markets. As the tide of liquidity continues to recede, we expect the most extreme excesses to continue to unwind and there will undoubtedly be more shipwrecks in 2023, some of which will be high profile and headline-grabbing. We have always steered clear of funds at the more speculative end of the risk spectrum and believe that we are well placed to weather any forthcoming economic storm.
Currencies
We wrote three months ago that ‘decades of experience have taught us that changes in exchange rates are notoriously difficult to predict and are therefore often as much a source of risk as of return’. So it proved in the final quarter of 2022 as the US dollar, which had soared in value against all other leading currencies in the first nine months of the year, reversed course both abruptly and violently. The catalyst was a change in expectations regarding interest rates and specifically that these would peak in the US and then begin to fall much sooner than in other countries. In addition, the dollar had simply appreciated by too much too fast. At the end of September, the dollar was up by 26% year-to-date against the Japanese yen, by 21% against the pound and by 16% against the euro. These are massive moves in the exchange rates of major currencies. In the final three months of the year the dollar duly depreciated by 9% against the yen, by 8% against the euro and by 7% against the pound. By the end of what has been an exceptionally volatile year, the dollar was up by 15% against the yen, by 13% against the pound and by 7% against the euro.
Although its momentum may carry it lower in the short term, we believe that it could prove foolhardy to bet aggressively against the world’s reserve currency. Not least because of greater self-sufficiency in energy and other supplies, it does seem probable that any recession in the US will be milder than in other major economies. In addition, the US Federal Reserve has consistently been more forceful in the fight against inflation than other central banks. It is therefore possible that interest rates in the US and other countries might not converge by as much or as fast as current consensus thinking. Despite recent efforts to restore fiscal credibility, Mr Sunak and Mr Hunt are not magicians who can pull a rabbit out of a hat. The UK faces formidable economic and financial challenges in the year ahead. We would therefore not be surprised if exposure to foreign currencies in portfolios is again beneficial to returns. Such exposure is provided by investments in international equity markets and, opportunistically, within strategic and tactical bond funds.
Alternative Investments
The price of gold rallied by almost 10% in dollar terms (the reference currency in which the precious metal is priced) in the final three months of last year. This completed a frustrating rollercoaster ride for the metal in 2022 during which it peaked in March with a year-to-date gain of 12%, troughed in September with a loss of 11% but ultimately finished the year at almost exactly the same price at which it began it. Reflecting swings in the US dollar/sterling exchange rate, gold was up by 2% in the fourth quarter and by 12% over the whole of 2022 in sterling terms. Given its reputation as a hedge against inflation, the fact that the price of gold started and ended 2022 at almost exactly the same price in a year when inflation was rampant is a disappointing and perhaps surprising outcome. The main driver of the price of gold, though, is ‘real’ interest rates which is the difference between interest rates and inflation rates. Gold performs best when real interest rates are falling and worst when they are rising. As 2022 evolved, however, rising interest rates were accompanied by growing confidence that inflation rates were close to peaking. If you believe that inflation is likely to prove to be stickier than expected then gold is not without its attractions.
Already reeling from steep price falls earlier in the year, the credibility of the cryptocurrency complex was dealt a further blow in November by the collapse of cryptocurrency exchange FTX amidst accusations of fraud and claims that up to US$8bn of investors’ money may be missing. Since its peak in November 2021, the total value of all cryptocurrencies has plunged from US$3trn to US$800bn. At the end of 2022, the price of bitcoin, the biggest cryptocurrency, stood at just over US$16,500, down by 15% over the quarter, by 64% over the year and by 75% from its all-time peak in November 2021. We continue to be attracted by the concept of a digital currency of which there is finite supply and which therefore cannot be debased by central banks. However, cryptocurrencies epitomise many of the worst features of the speculative bubble inflated by years of ultra-cheap money. Much as it goes against the whole ethos of cryptocurrencies, greatly increased regulation is perhaps the only way that credibility can ever be restored.
Another quarter has passed and there has still been no decision from the FCA about the future of daily dealing UK authorised property funds. This is now expected sometime in the first quarter of this year but as previous deadlines have been missed we are not holding our breath. We note that the IA UK Direct Property Sector index fell by just over 7% in the final quarter of 2022 and was down by just under 6% for the whole year. Our concerns about the mismatches in both liquidity and valuation frequency of daily dealing funds and the assets in which they invest remain. This seems to us to be an asset class better suited to permanent capital, for example in the form of stock exchange-listed investment trusts. Regardless of our opinion about the prospects of the sector in a recession, we will remain on the sidelines until the FCA has determined the future of UK authorised property funds.
Important Information
All factual, numerical data has been sourced from FE fundinfo or is readily available on the internet.
Our thoughts expressed in this report relate only to the portfolios we manage or advise on, on behalf of our clients and as such may not be relevant to portfolios managed by other parties.
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