Despite the fact that the valuation period (5 October 2022 – 5 January 2023) was marginally positive for financial markets, we are grateful the curtain has finally come down on 2022.
This time last year we argued that the inflation we were then experiencing was temporary as it had been caused by the coronavirus outbreak, as supply-chains were seeing significant disruption thanks to government restrictions and staff shortages due to isolation requirements.
As a consequence, at the time we believed that while the rate of inflation would continue to climb in the first few months of 2022, it would then start to fall back to towards central bank targets of 2%.
Unfortunately, Russia’s invasion of Ukraine put an abrupt stop to that temporary view as the prices of oil, natural gas, metals and food suddenly surged – although as Niels Bohr, the physicist best known for his work in atomic theory once said, “prediction is very difficult, especially if it’s about the future!”
These price increases not only exacerbated global inflation, but they prompted almost every central bank (including the Federal Reserve, the Bank of England and the European Central Bank) to start aggressively increasing their interest rates.
In fact, US interest rates increased from 0.25% at the start of 2022 to 4.5% today, while in the UK interest rates rose from 0.25% to 3.5%. Consequently, these have been the most aggressive tightening campaigns in decades – and even more so, when viewed from the low starting position (effectively zero) to which we have all become accustomed.
Not only did 2022 see our debt servicing costs rise and our incomes fall relative to inflation, leaving us facing the worst cost of living crisis in a generation, it was also a brutal year for financial markets: for example, the world’s largest equity index, the S&P 500, fell just over 19%, while technology stocks, which have provided strong returns for well over a decade, typically saw declines in excess of 33%. Even government bonds, which by and large retain their value during periods of economic uncertainty, had their worst year that we have ever experienced as the price of the 10-year UK gilt benchmark fell by over 20%.
Negative markets are never pleasant and although it is of little consolation (as our portfolios were by no means immune from these losses), our disciplined process, diversification and active management did help to protect against bigger losses. Over the same 12-month period a typical Cautious-risked client lost 8.16%; Balanced was down 1.60%; and Adventurous -1.73%. In fact, unless we only invested your portfolio predominately in companies with exposure to tobacco or oil, it was inevitable that your portfolio would have a negative performance in 2022.
However, of more use and interest is what might happen rather than what has already happened. For 2023, at the top of our Christmas wish list was an end to the war in Ukraine, followed by central banks cutting interest rates and a rebound in Chinese economic growth.
Given the damage inflation has wrought on financial markets in 2022, you may be slightly bemused as to why lower inflation was not top of our wish list. This is because inflation in most major economies is already falling, helped by the fact that supply chain disruptions have now largely resolved themselves, meaning costs such as those for a shipping container (and therefore the cost of moving goods around the world), have now largely declined back to their pre-coronavirus levels. Furthermore, the price of a barrel of Brent oil is, today, just below $80, meaning that it has completely given back all of last year’s gains, having peaked at nearly $140 shortly after Russia’s invasion. It is a similar story for natural gas prices thanks to the mild winter weather we have seen across Europe.
On top of that, high base effects are providing a strong tailwind as the reported inflation rate reflects annual changes – and given the sharp rise in inflation over the past 12 months, it only needs a slower increase in inflation over the coming months to arithmetically produce a disinflationary environment. Consequently, the significant increase we saw in global inflation during 2022, is likely to be equally matched with a significant decrease during 2023.
It isn’t that inflation suddenly doesn’t matter, but of more concern to us is the extent higher interest rates and the cost of living is starting to weigh on our ability to spend: our consumption drives 60% of the UK’s GDP, while in America, the consumer accounts for two-thirds of the economy.
While it has become trite to say that a recession is inevitable, that doesn’t mean to say we are in for further pain in 2023.
Financial markets don’t move in real time with economic activity – they tend to front run the economy – and as such we believe that thanks to last year’s falls, financial markets are already discounting (in other words they have already priced-in) a significant economic contraction.
While central bank policymakers are currently talking tough about the need for higher interest rates, given slowing inflation (and the risk of deflation), coupled with a recession, we believe central banks will soon not only announce an end to their interest rate increases, but will look at cutting interest rates to boost economic activity – and this is positive as it should provide plenty of upside potential for both equities and bonds.
Income Element
Last year bonds returned the biggest losses in a generation as central banks around the world increased interest rates with a speed and simultaneity not seen for decades.
But peak interest rates may actually be a lot closer than policymakers are currently suggesting – and if central banks take a less aggressive path with interest rates, yields will undoubtedly drop and prices (which move inversely to the yield) will rise as bonds tend to do well in environments where inflation is falling and central bank policy is accommodative.
As such, our strategy of holding a diversified spread of secure companies with investment-grade credit ratings and stable income until their maturity continues to look sensible.
Long-Term Growth Element
Headline inflation readings suggest inflation has peaked, and given last year’s energy price shock has now unwound, we believe central banks around the world are soon likely to switch to a more accommodative stance in an attempt to ensure their respective impending recessions are short and shallow.
In fact, these approaching recessions are probably the most anticipated recessions we have ever seen.
Whilst we appreciate the pain from the losses endured during 2022 are still at the forefront of your thoughts, a recession doesn’t automatically mean there is more pain to come: global equity markets are down significantly from their all-time highs – which suggests to us that the risk of the impending recessions have largely been discounted.
What’s worth saying once is worth saying multiple times: the path for equity markets is never smooth or easy, simply because investing in equity markets is risky. However, it is obviously riskier if one has only a short-term time horizon – the longer one is prepared to invest, the less risky it will become, as equities have historically weathered inflationary and recessionary sell-offs similar to those we are facing today.
In fact, global equity markets can deal with any eventuality, they simply hate periods of uncertainty and as such it is not uncommon to see negative equity markets returns such as those we encountered in 2022 – although uncomfortable, these negative periods tend to be reversed allowing long-term investors to come out on top.
Within our equity portfolios, we continue to like UK equities as around two-thirds of the FTSE-100’s total revenue is derived from abroad (meaning the majority of the companies in your portfolio will be relatively well shielded from a UK recession).
However, during the valuation period we did lower the UK exposure slightly. This predominately came from trimming holdings in the oil (BP & Shell) and commodities (Anglo American, Glencore and Rio Tinto) sectors. Although all these holdings remain well positioned thanks to their strong cash flow generation, after a strong 2022, continued outperformance may be limited if we see lower production volumes and/or a deterioration in oil and commodity prices – if, for example, the global economy has a deeper or longer recession than we are currently expecting.
We again added to holdings in Asia and Emerging Markets. In addition to the region’s good long-term growth story (positive demographics and a growing middle-class population), short-term economic growth is positive following news that Chinese authorities were relaxing the country’s coronavirus policies (which should see China’s growth, in particular, significantly reaccelerate).
Investment Management Team