Market Update 3rd May 2022 from Jilly Mann

Posted by Telford Mann

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Market Update – “I think ever since you came into office, things are really looking up, you know. Gas is up, rent is up, food is up, everything.” (Trevor Noah to Joe Biden at the White House Correspondents Dinner)

• Global Markets year to date
• US politics and the French election
• Technology – not all technology is the same
• Ethical Defensives
• Defensive value – what is it and where is it
• China – Covid #2
• Recession & inflation – will we, won’t we
• Our Property Allocation
• Conclusion

It is fair to say that 2022 has thus far proffered more questions than answers for investors, not least among those questions being where are the returns, in an environment that at face value seems only to offer reasons for worry rather than hope. This update aims to address many of those worries and explain where we believe there are positive returns to be had now that various economic and geopolitical situations are becoming clearer.

Global Markets year to date

It has been a tricky start to the year for most global stock markets. The graph below demonstrates the returns from five of the leading stock markets across the globe.

The chart shows the FTSE 100 (UK) in black, the Hang Seng (Hong Kong/China) in purple, the Dax Xetra (Germany) in green, the S&P 500 (US broad index) in blue and the Nasdaq 100 (US technology) in red. The FTSE 100 is the only index of those charted which has recovered to be marginally positive year to date and at +0.52%, it is only marginal. The Nasdaq 100 is down over 22% so far this year, the Dax as a proxy for developed Europe is understandably down over 12%, but it is perhaps instructive to see that the S&P 500 has performed worse (-14%) than Europe thus far and the Hang Seng at -9% is the second best performer after the UK.

Now, one can extrapolate any date over any time period and include any index, so this is but a snapshot, however, these five markets represent the majority of the developed world’s investor universe and so they do matter. What is in no doubt is that 2022 has not been a smooth ride so far. Every market on that chart has experienced significant rises and falls. One thing it does reiterate is the necessity to be in the market, because one doesn’t know when the bounce will happen. For investors becoming twitchy about the FTSE 100 in early March 2022 as it approached a fall of 8%, the recovery to parity would have been missed had they sold at the bottom. It never feels comfortable, and it always hurts most when it is happening, but markets do and will recover. The questions we have been asking as we watch this activity happening is how, when and what is best placed to lead us through the next phase of the market cycle in 2022.

US politics and the French election

Turning to politics, the French election has been and gone since our last update. Emmanuel Macron was predicted to win the election and he went on to beat Marine Le Pen by a relatively comfortable margin in the end, albeit with a low voter turnout. For stock markets, the election of a less potentially controversial figure should have provided a boost, but it was a mark of how expected his victory was that markets hardly moved at all as a result. Had he lost the election though, we would have seen a big swing the other way, thankfully that did not happen. Domestically, Macron continues to face plenty of challenges, but French companies have actually been performing quite well of late and he himself has become an increasingly central figure in negotiations directly with President Putin regarding the war in Ukraine, so continuity has been welcomed in that regard.

US politics is in an interesting place at the moment. The quote which heads up this Market Update was from Trevor Noah’s address at the White House Correspondents’ Association Dinner and rather sums up but one of the issues President Biden faces. Inflation is a major concern for US citizens, just as it is across the globe, but Biden doesn’t seem to have any answers to deal with it. His popularity ratings, which were also the subject of a few barbs at the dinner not least from Biden himself, are the lowest of any US President. His Vice-President Kamala Harris is faring even worse and so if many commentators expected Biden to hand over the reins to Harris before the 2024 election to try to provide a smooth transition of power, that option presently doesn’t appear viable.

The US Mid Term elections are due later this year and it is widely expected that the Republicans will do better than the Democrats and thus take control of the Senate. This means that if Biden has so far failed to implement many of his domestic policies with the control he presently has, he will have next to no chance of implementing any policies after the Mid Term elections, if results go as predicted. This is not great news for domestic policy as the stalemate will likely last until the 2024 US Presidential election, but it is something we need to factor into our investment allocation.

If very little is going to change in the US over the coming months and years, we do have a sense of certainty and so we are able to invest in areas which we think will benefit from the status quo, without the likelihood of too many policy shocks affecting those companies.

It is the reason why we remain overweight to the US. That may seem counterintuitive (given recent market performance), but the US remains the world’s largest economy and whilst there are many areas that we do not want exposure to in the US, they remain well placed to fill the void for energy supply, renewable energy components and exports when there are so many challenges facing Europe and Asia.

Technology – not all technology is the same

The technology sector is heavily weighted towards the US. The Nasdaq 100 index we highlighted earlier is the US technology index and one finds all the big technology names within that; Alphabet (Google), Netflix, Meta Platforms (Facebook) and Tesla. There are many others beside these. What has changed in the way technology is viewed though is the sweeping view that all technology companies are the same. It isn’t true. There are defensive names within the sector, we just need to find them.

The chart above charts the performance of Microsoft (purple line) against Netflix (black line) since the start of the Covid Pandemic in March 2020. Whilst there wasn’t much between the two stocks initially, as the world started to open up again from lockdown and the pandemic became something we learned to live with, Netflix shares have plummeted whilst Microsoft shares have dipped from their peak, but fell nowhere near as much. Netflix represents many of those technology stocks which saw an opportunity in lockdown, maximised it, but now realise they have very little substance to fall back on once subscribers realise that they don’t need to stay at home and watch Netflix to fill their days and perhaps more pressingly, they can’t afford the luxury of a Netflix subscription in a world where they are struggling to pay their energy and food bills.

Technology is often reviled or loved as a sector en masse, but the reality is very different. Stocks like Netflix are quite definitely not defensive stocks, they are stocks that will come and go with fashion and affordability and so when the going gets tough, they will struggle to remain relevant. Stocks like Microsoft and increasingly Tesla are technology stocks, but technology that we will rely on in good times and bad. Very few of us can work without Microsoft, that alone doesn’t protect the shares from falling at times, all stocks fall at times, but it does mean that they can be regarded as a stock that will retain their value and market share when the economic outlook is less favourable. I would include Tesla within that category as well. Very few commentators can explain the inexorable rise of Tesla shares and even fewer feel comfortable with it, but the reality is that Tesla are leading the pack for renewable energy and electric automation. Everyone else is still playing catch up, whilst they continue to bring out new ideas. This won’t last forever and perhaps the situation in Ukraine will focus more minds on renewable technology, but for now, there aren’t many alternatives and that again gives them monopoly and market share that in itself makes their shares behave in a more defensive manner.

Ethical Defensives

Whilst covering Tesla, our ethically minded investment strategies have seen a number of fund changes within them. When reviewing our investment portfolios, we have reviewed which funds have performed well over the last six months and so are better suited to holding up well in a more challenging environment. The encouraging news is that we are starting to see more ethically minded funds being launched, often with a broader investment remit and this broadens our universe of funds to consider. The difficulty is that ethically minded funds are typically less defensive in nature. The holdings they invest in are often more slanted towards newer technology which perform well in a broadly positive market as they are heavily growth orientated with greater upside potential than more established stocks. The reverse is true in a more defensive market. We have found strong options for the ethical strategies which have delivered over the last few months, but as a result we have had to switch out of a number of names, such as Liontrust’s sustainable range, funds which typically we think offer much greater upside returns, but we just don’t think they are best suited for the environment we are in now.

Defensive value – what is it and where is it

When we construct the portfolios, we look to balance risk and reward. For example, at the moment European stocks undoubtedly look cheap on paper. They have fallen in part because of the war in Ukraine, but also because Europe structurally faces similar challenges to the rest of the world in terms of inflation as it recovers from the pandemic, but Europe are not in a position to focus so heavily on the recovery phase due to the war on their doorstep. US stocks look more expensive in comparison to European stocks with less obvious upside potential across the board. Our positioning though is overweight the US and underweight Europe. The European allocation we now have is focused on defensive value stocks, i.e. those whose cashflows have continued to hold up over the last couple of years and who are either more insulated from wider developments or directly invest into stocks which will be beneficiaries of the challenges in Europe, such as semiconductor companies (ASML in the Netherlands) or freight (Maersk in Denmark). Less flashy, more boring names who are inflation-proofed and involved in industries that Europe needs. Overall, our view is that when comparing potential returns from the US and Europe, the US presently presents less risk than Europe for similar returns, hence our portfolio positioning.

Infrastructure is another sector we have increased our exposure to. The L&G infrastructure holding we have owned in recent months has been a strong performer in the portfolios and we have added the First State Global Listed Infrastructure fund in lieu of other global funds which were focused more on growth, via smaller company names. First State offer greater inflation-proofed returns in businesses that will still be needed irrespective of the war in Ukraine or the pandemic.

In the UK we have changed our allocation to remove our smaller company exposure. Longer term, we think smaller companies present much greater return opportunities than larger or mid cap holdings in the UK, but at the moment, the UK is dealing with increased inflation, energy tariffs shooting up and increased national insurance deductions. Come the Autumn, we will see how the energy price cap affects energy prices in the UK. That currently seems to be the UK Government’s stance on the problem, wait and see if the problem resolves itself before taking action. However, the sector of the UK economy which will most likely be impacted by this three-pronged challenge is smaller companies. Despite companies stockpiling cash during the pandemic and so appearing to be in a relatively healthy position, there may be more of a thought towards holding back on spending that cash whilst these three factors settle down.

In Asia, we have swopped our Emerging Markets equity exposure for Asian Income. Income funds typically offer a more defensive approach as they seek companies who actively pay a set level of dividends, who are by their very nature more inflation-proofed businesses with proven experience in working through economic headwinds.

The chart above shows the Jupiter Asian Income fund, which is a new addition to our portfolios. The manager, Jason Pidcock, previously managed Asian Income and Global Emerging Market Income funds at Newton and we owned both of those funds for some years. He subsequently moved to Jupiter and we have been monitoring his fund to see when it would reach a size that meant we could invest into it to a meaningful degree. Quite apart from the fund standing out as having achieved a positive return year to date, in contrast to the indices we reviewed earlier on, the chart aptly demonstrates the benefits that a quality income fund can bring to a portfolio. The orange line shows the return from the fund excluding any dividend income, 3.80%. The blue line shows the total return from the fund including any dividend income, 5.56%. The time period represents less than half a year, but an uplift of 1.76% year to date is much higher than most dividend paying funds are achieving at the moment and should hopefully gives us some stability as well as exposure to the growth engine of Asia.

China – Covid #2

The introduction of the Jupiter Asian Income fund leads onto the situation in China. Where in our last update, the signs emanating from China were more encouraging with economic stimulus underpinning a resurgence in the stock market and a relaxation of the curbs on technology businesses by the Government, encouraging greater investment back into the region. The situation today has regressed with the total lockdown imposed on Shanghai, having caused consternation in the region and on the stock market. This lockdown has in turn led to global supply chain worries as Shanghai’s port has all but ground to a halt. If sourcing alternative energy sources to Russia in next to no time wasn’t a big enough issue to for western economies to address, developing a supply chain that doesn’t rely on China is the second big transformation which countries are grappling with. It isn’t all bad news in China though. The news surrounding China is generally overdone on the positive and overdone on the negative but had Covid mark 2 not turned up and the Government taken such an extreme stance, there were some reasons to be hopeful on some stocks. It is hard to imagine that the Chinese Government will want the present situation to continue indefinitely, if nothing else it harms their ability to pick up trade on the back of Russia’s exile, but the situation remains uncertain and so on the balance of risk and reward, we feel that the Jupiter Asian Income provides us with the minimal Chinese exposure we need and want in current conditions.

Recession and inflation – will we, won’t we

When it comes to recession theorists, the clamour is growing for an inevitable recession hitting global economies as we move through 2022. A point to note though is that the world has been moving through economic cycles on fast forward since the Covid pandemic and so even if a recession does occur, it may not last as long as economic historians would lead us to believe. In terms of will a recession definitely hit, well maybe yes, maybe no. Technical recessions, i.e. a period of two consecutive quarters of declining GDP, have happened since the Global Financial Crisis of 2008/09, but Central Banks and Governments have done everything in their power to prevent an all-out prolonged recession from happening. This has distorted so many things. This time, a recession may not come about solely as a result of financial markets and so Central Banks are now less in control than they have been over the last 14 years. The pandemic recovery and war in Ukraine are not aspects they can so easily manufacture an outcome from or inflate away through Quantitative Easing.

The bond market is signalling that a recession is imminent, and we had previously reduced our bond weighting within our portfolios, because neither the yield nor price return were protecting investors. With bonds comprising the traditionally lower risk element of our portfolios, the steady declines were such that we had to take action. Over the last week, we have seen some hints of an inflection point in bond markets. As with equities, we need to be selective about what bonds we own and when. Bonds with longer duration, which essentially make them less exposed to short term market movements and high credit ratings, either corporate credit ratings or developed world Government debt, feel like the areas where a prolonged inflection will happen first and so these are the areas where we are positioning our portfolios towards. If bonds can return to an environment where they deliver 3-5% per annum to portfolios, bonds would be back delivering the returns we expect within our portfolios.

Our property allocation

To aid the defensive positioning of our strategies, we have also increased our weighting to Commercial Property, by bringing the L&G UK Property fund back into our portfolios. This is a fund we have held in the past to great effect and the reason we consider this property fund over others is due to its highly liquid make up. With around 25% in cash, some investors may question this liquidity and how the lowly return on cash would affect overall returns, but the L&G fund has kept pace with the BMO UK Property fund, and it is that very liquidity which means it has not fallen into the traps which other massive UK property funds have fallen into. The BMO fund has produced 4.6% year to date and the L&G fund has returned 5.36% to date to further inflation proof portfolio returns against a backdrop of two years where the fund’s asset book has been reviewed and refreshed in light of the pandemic with the much-derided retail high street allocation only comprising 1.6% of the L&G UK Property fund portfolio.

Conclusion

In an ideal world, investor portfolios would be protected from falls and would only experience upsides. I can assure you that we aspire to achieve that, but stock markets sadly move both up and down. Whilst the start of 2022 has been hard to decipher at times, we feel that markets are in a clearer position than they have been in recent months. Uncertainty abounds over what China does next, will Putin survive his operation and continue his campaign against Ukraine beyond Russia’s victory day on May 9^th, will Russia move onto Moldova, will Central banks continue to raise interest rates or will inflationary signals resolve themselves. We do not have the answers to any of those issues, but we do feel that the defensive strategies we have put in place will hold good in the wake of the geopolitical and economic questions facing markets. If everything is resolved overnight and all of the worries disappear, these defensive strategies would not keep pace with a roaringly bullish stock market, but we don’t foresee that scenario in the near future and so our focus has been on assessing where we are, what are proven winners for this environment and how can we use those winners to deliver portfolios to protect our investors.