Log inMarket Update – 21st December 2022, not the year markets wanted, but perhaps the year they needed
As 2022 draws to a close, many of our clients are wondering if 2023 will be better and where, if anywhere, we are looking to find investment opportunities for the year ahead.
As ever, the answer isn’t black and white. This update will highlight why we continue to be defensively positioned for now, but how we do see a path to recovery for markets.
- If something is defensive, why doesn’t it always go up?
- Where next for UK markets?
- How long could a recession last and how much impact could it have?
- Why the US story could be different
- China’s reopening and the impact on commodities
- Conclusion
If something is defensive, why doesn’t it always go up?
We have been talking about our defensive positioning within our portfolios for the better part of 2022. It is important to acknowledge though that, despite our best efforts, defensive unfortunately doesn’t guarantee that portfolios cannot fall in value. Defensive does mean that portfolios tend to fall in value less than the broader market. We always maintain that no fall is good news, but we do need to keep in mind the context within which we are working.
The chart below updates the position of our Score 3 Moderately Cautious Growth (blue), Score 4 Moderate Growth (orange) and Score 5 Moderately Adventurous Growth (yellow) strategies against major global indices since the start of 2022.
The FTSE All Share in light purple has offered glimpses of a positive return throughout the year, but whilst it has rallied in the last month, the chart shows that it gives up those gains just as quickly and so is far more volatile than our strategies have been. I think this chart sums up what we mean by defensive. In an ideal world, we would only ever participate strongly in those short-term rallies, but then stay flat rather than drop back. As I will go on to explain, I don’t think we are in an economic cycle whereby certainty of rises and falls is available. Our score 3 strategy is currently down 7.89% for the year, our score 4 growth strategy is down 8.54% year to date and score 5 growth is down 9.15%. None of those numbers make us particularly happy, but against the context of the German DAX index being down over 12%, the FTSE 250 being down over 18%, the leading US S&P 500 being down 19% and the US Nasdaq technology index being down over 31%, our defensive nature has avoided the worst of the equity losses for the year.
I must reference the ethical strategies at this juncture. 2022 has not been kind for ethically minded stocks. True ethical stocks are not designed to be defensive. Their raison d’etre is to seek out and support new technology which can become the bedrock in the future for the challenges climate change presents. We constantly review the investment options available to us. We have chosen the most defensive options we can find, but we have to strike that balance between shielding portfolios in uncertain markets and moving too far away from the ethical mandate which our investors seek to follow. We saw through the early part of the Covid pandemic that the tide turned the other way for ethical investment and they led the way in terms of positive returns for investors, ahead of more traditional investment types and so their time will come again, but it is undoubtedly a less smooth ride for ethical investors in this type of fund. Ironically, perhaps the reason why the UK and Europe have thus far managed to keep energy supplies going in the face of the Ukraine/Russia war has been due to the past investment into alternative energy supplies. Unfortunately, that call on supply hasn’t been enough to reward investors in recent months.
Where next for UK markets?
The previous chart showed quite a divergence between the FTSE All Share and the FTSE 250. The FTSE All Share down 0.95% and the FTSE 250 down over 18% for the year. We haven’t held a position in UK equity funds in recent weeks, although we have maintained some exposure through our global funds and natural resources allocation. With hindsight, it would be easy to say we should have owned the FTSE All Share and participated in the November rally we showed earlier. I think that would be short-sighted and would run the risk that we think many investors are taking at the moment, of panicking to chase returns whilst forgetting the risks.
The rally in the FTSE All Share during November coincided with the Pound strengthening as the Dollar weakened. That movement is good for FTSE 100 stocks and negative for US stocks. The chart below shows that we did actually benefit from that UK movement by way of our L&G All Stocks Gilt (red) and Liontrust Sustainable Future Corporate Bond (green) allocation, which we incorporated into our strategies in early October. N.B. the FTSE 100 is shown in blue. The Liontrust fund has returned over 11%, the FTSE 100 over 6.6% and the L&G fund over 3.7% since the 3rd October 2022.
It is remarkable how quickly the markets have shrugged off the Kwasi Kwarteng and Liz Truss budget of earlier in the year. Rishi Sunak has restored order and credibility to the UK, but my reference at the start of this update of a path to recovery is aptly summed up by this chart. We believe that there remain question marks over how well the UK can manage the next phase of the economic cycle. The UK isn’t in as strong a position as the US economically. We don’t think that interest rates will rise hugely from here nor will inflation stay anywhere near as high as it presently is, for much longer. However, bringing both under control from those relative highs will take some managing. The currency has stabilised from the crash of the short lived Truss Government, but again we would suggest at the moment that the Dollar is a stronger position to hold than the Pound. Therefore, our exposure to the UK remains via certain global equity funds, but increasingly by way of fixed interest allocation.
The path for recovery for the UK appears to me to be a cycle through fixed interest strategies before rebuilding a position in selected UK equity stocks over a period of time. We have just trimmed our Gilt weighting in lieu of additional corporate bonds in the UK as we don’t expect Gilts to rally as strongly as we have seen in the last quarter, but there remains plenty of scope for corporate bonds with strong credit ratings to prosper in the months ahead. If we can pick up positive returns from fixed interest without the potential uncertainty of UK equities, then we will continue with that more defensive positioning. I appreciate for investors that is a harder one to follow as bond markets are less quoted in the press than the FTSE 100 and at times we will miss out on short sharp rallies, but we don’t believe those equity rallies are sustainable at the moment and as fast as they rise, they have tended to come down. Trying to time such events with such a lack of conviction would be foolish to our mind.
How long could a recession last and how much impact could it have?
The following chart is perhaps not the most straightforward to understand, but I think it helps to illustrate why we fall more in the defensive bear camp than in the chasing bull camp when we view markets. We haven’t seen inflation rates such as we are experiencing at present since the 1970s. Back then, the US made the mistake of pivoting their stance too soon. They took their foot off the pedal, ceased raising interest rates in the belief that they had brought inflation under control, only to find inflation soared ahead again and the interest rate pain worsened. The Federal Reserve are haunted by repeating this same mistake.
The problem is that markets continue to try to bully Central Banks into pivoting. In our industry, pivot has become the new buzz word. Last week, Jerome Powell of the US Federal Reserve made it clear that he was not ready to pivot and whilst the latest interest rate rise in the US was 0.5% rather than 0.75%, he didn’t imply that future rate rises would cease or be significantly lower. Christine Lagarde of the European Central Bank (ECB) was even more explicit when announcing the latest European rate rises, by stating that nobody should interpret the ECB’s actions as a pivot. Andrew Bailey of the Bank of England is watching what is happening in the US especially closely and whilst UK rates may not reach 5% by the end of this cycle, the challenge is not bringing inflation down, much of that will happen naturally as the cycle evolves, but it is bringing inflation down from a sticky 5% rather than the double digit inflation we see today.
This is why the chart below matters to Central Banks. If Central Banks target inflation at 2-3%, then history shows that it takes a long time to tackle all aspects of inflation and hit those lows. The chart shows that the higher inflation reaches, the longer it takes to bring back down under 3%. If inflation hit 4% then it could take less than a year to bring back down to sub 3%. However, if we look at inflation of 10%, it could take over 10 years to bring it all the way back down to the 3% target.
That may feel like a particularly gloomy outlook, but there are some nuances to consider. In the US, inflation has little to do with energy relative to the UK and Europe. All economies are still pumped up by Covid support payments which are being utilised to keep consumer spending artificially high in this elevated inflation world we live in. Jobs data is questionable. In the US, there is conjecture over the validity of some of the jobs numbers being quoted. Whilst in the UK and Europe, the war in Ukraine as well as the impact of Brexit during the Pandemic have also distorted jobs numbers to some extent. What this means is that Central Banks have slowed down and reduced interest rate rises, but they aren’t inclined to commit to a pause, far less a reduction, until the data becomes much clearer. For this, they need time.
They need time to assess the impact of the measures they have taken so far and they need time to get through the winter and review which aspects of inflation have taken care of themselves. One could expect that energy inflation will fall markedly through 2023, assuming of course that Russia doesn’t do anything more extreme in either Ukraine or broader Europe. If energy inflation comes down in the UK and Europe, then because that comprises such a large proportion of our inflation measure, the overall inflation number will drop significantly, whilst still remaining far above the 3% target. This is also the challenge which the UK Government faces when talking to the Unions about industrial action. If the overall inflation figure in Summer 2023 is purported to be much lower in the UK than it currently is, examples of rail unions purporting to reject 9% payrises will impact the UK economy, but again this will take time to pull through into data in early 2023.
There are more variables in the UK and Europe when we look at equity prospects. Managed well, then the recession may not induce much more pain than we have already experienced and certainly we wouldn’t expect to see the same level of falls in equity markets that we have experienced this year, but that picture isn’t clear enough for us yet.
Why the US story could be different
Our view on the US is different. A recession in the US is unlikely to be as long-lived or as severe as it could be elsewhere in the world. We have maintained a higher exposure to US equity, albeit avoiding technology stocks where possible and we are actively looking to increase our exposure to US domestic stocks. The US Dollar dipped during November, but we don’t anticipate the Dollar continuing to fall. Far too much rides on the US Dollar for that and we simply don’t see sufficient signs from alternative currencies to suggest that they are in a stronger position than the US to recover. We would expect short term fluctuations, but we aren’t supportive of a view that the US Dollar will weaken significantly from here. Being mindful of Dollar movements though directly influences the US holdings which we own.
The global equity story isn’t all negative, but it is selective and there is an element of patience required. Willing the markets to rise against economic guidance feels premature at the moment, but we are starting to rotate our equity exposure into areas where we will pick up returns from quality companies irrespective of the recessionary environment they may be operating in. As a result we have increased our exposure to our JPM and JO Hambro global equity funds, whilst selling our Artemis holding, on the basis that the Artemis fund is unlikely to perform as strongly in the next phase of the economic cycle.
China’s reopening and the impact on commodities
China has finally relented on the zero Covid policy which has been in place since the start of the pandemic. The expectation though is that China now has to go through the experience, which the rest of the world experienced upon reopening which is a wave of Covid infections and variants. They have already had to shut some schools in China as a result and who knows if this opening up will be sustained or if it will be the stop/start experience that the rest of the world went through.
China’s stock market rallied strongly when zero Covid ended. The chart below shows the IMA China index over the last month:
The China sector gained over 12% in a fortnight, but it has noticeably flattened since. This has coincided with reports of rising Covid rates in China and so until we see how they handle this in the coming weeks, it is hard to suggest that China is back as a global force to drive markets up. That is not to say that we are looking to invest back into China directly, but China has a huge influence on Asian trade and global trade. The consumption of commodities is often linked to how much industrialisation China is working on. The reality of the pandemic is that many economies have found alternative trading partners, have improved domestically and have survived without China to a great extent. That said we cannot ignore the impact that a reopened, trading China could have on global trade and so we monitor what is happening in the Chinese market closely.
Some commentators have started to signal a buying opportunity in emerging markets in the hope of a weaker Dollar and a reinvented China, as you may expect we are much more defensive on this point. Emerging markets as a whole face challenges, the situation in Brazil and Peru following the recent election and ousting highlights the extremes of hope and despair that stalk those markets at present. Our Asian exposure is via the Jupiter fund, which is as defensively minded as we can find, but we have also reintroduced the Fidelity Asian Opportunities fund as a small allocation. This is another good example of a move that we see as commensurate for the cycle we are in. The Fidelity fund is about quality holdings with strong balance sheets and no dependence on any one economy. This fund can only benefit from the sentiment of China starting to re-engage in the broader Asian market, even though it is not reliant upon it.
We have slightly trimmed our commodity weighting, but we retain a reasonable exposure. Commodity prices have fallen recently if one looks at oil as an example, but gold has started to become a safe haven for investors again as uncertainty over equity markets abound. We accept that commodities aren’t always going to perform in our portfolios, but in times of inflation and global conflict, we need to have exposure and I wouldn’t be surprised to see that exposure ramp up again in 2023.
Conclusion
I explained at the outset that investments weren’t black and white at the moment. A recession doesn’t mean markets have to fall, but we are finally seeing fixed interest markets and equity markets move in different directions. This means portfolio diversification has returned after years of absence. This gives us optimism that has already borne fruit in recent weeks that irrespective of what happens in equity markets, we can generate positive returns from fixed interest with far less uncertainty than we saw through 2022.
Inflation and future interest rates are not black and white. Time and data are going to drive Central Banks, not markets. We have been positioned for that during the latter part of 2022 and it hasn’t always rewarded us, but it is clear that Central Banks would rather be late to pivot than early, which supports our continued defensive positioning and should reward it rather better in the year ahead.
2022 was remarkable for the way it treated fixed interest, currency and equity so harshly in unison. We finally seem to be returning to a recognisable economic cycle. Regular readers will know that I like my historical references and records. Records are there to be broken, as anyone following the England men’s cricket team at the moment would attest, but by and large history all too often does show us the way forward. 2023 may be tough for some markets, but we don’t expect it to be tough for all markets and we hope to be rewarded for the active management we are undertaking as we move through the next phase of this economic cycle.
It leaves me to thank you for your feedback on these updates through the year and wish you all a Merry Christmas and a Happy New Year.