Market commentary: 1 June 2022 to 30 September 2022
We finished last quarter with a sombre outlook: “As things stand at the end of the first half of 2022 we have a high conviction over the following: that inflation will persist, interest rates will rise, recession is coming and that high asset values cannot withstand these forces.”
Not much revision is needed to this as we enter the final quarter of a difficult year for investors.
To recap the performance of the asset classes so far this year:
The FTSE100 has been the strongest performing of all of the international benchmarks reflecting its underlying value and the concentration of oil and mining stocks. To give some idea of its strength, it has outperformed the NASDAQ (the tech heavy US benchmark) by 26% this year, the S&P 500 (the broader US equity benchmark) by 19% and European benchmarks by 18%. As we have been significantly overweight UK equities this should be a moment of satisfaction. But for one thing: £ sterling.
The US dollar has been storming ahead of other currencies to a degree seldom experienced in modern times. It has risen in 2022 by 14% against the € Euro, 17% against £ GBP sterling and 20% against ¥ Japanese yen. Classically a currency will appreciate if expectations are that its interest rates will rise faster than its comparator or if its economy will perform notably better for some reason. At the fringes this is true of 2022. The Fed has been more aggressive in raising interest rates, though not to the extent it has regained the credibility it lost for being so obviously asleep at the wheel as inflation gathered speed. It is also probable that the US economy (though destined for recession along with the rest of the world) is likely to perform better than other developed economies; it is a structurally more dynamic economy. However, the differential in interest rate rises and economic growth in no means justifies the scale of the dollar appreciation.
Because of this the significant outperformance we secured for our clients by being overweight in UK equities was almost completely undermined by the $ US dollar rising to cancel out that effect.
Debt investments have had a torrid 2022 – the worst year for debt investors for a generation. UK government debt (gilts) with a 10 year duration (until the money is paid back) have lost 25% of their value so far this year. This is a remarkable downturn in what is supposed to be the only “guaranteed” investment there is. Similar stories are to be found when looking at corporate debt and other fixed interest instruments. The reason for this crash in gilt values is because interest rate expectations have risen. One year ago the benchmark UK 10 year gilt had a yield of 0.8%, today it is 3.8%.
Our debt investment strategy has been to focus solely on the highest quality (US and UK sovereign) debt and index-linked gilts (which give a measure of protection against rising inflation) and only short duration. We intentionally avoided any corporate debt and any long duration investments. Looking back over 2022 we could not have materially improved upon this positioning. For context the debt element of our client portfolios has outperformed its peers by around 18% this year – protecting our client’s wealth when others have experienced steep losses.
At the start of the year the story was one of supply squeezes and geo-political risk after the Russian invasion of Ukraine. Oil and gas rose steeply as a result of the concentration of supply from Russia, though this has been dissipating in recent months. Gas prices have more than doubled over 2022 though oil now stands just 10% higher than it did at the start of the year. At the other end of the investment spectrum, we have seen Bitcoin (-63% ytd) and other crypto coins plummet in value.
A recent FT interview on the subject with one of our partners (Max Thowless-Reeves) is here
This remains a very difficult investment backdrop for investors. Interest rates are rising which undermines support for equity prices and reduces the price of debt investments. Inflation is rising making everything more expensive and, as we were saying forcibly at the same time as the 400 PHD’s of the Fed were insisting that inflation was transitory, it is here to stay. Economic growth is slowing and going into reverse – consumers cannot experience rising housing costs and rising (pretty much) everything costs without reducing discretionary spending. The high energy costs will mean a cold winter for many and higher costs for business and a general drag on the economy. At the beginning of 2020 the % of global GDP represented by energy was 2%, now it is 13% – at any level above 7% it is estimated that output is unsustainable and will contract.
A deep and prolonged recession is in place as the excesses of the last 15 years of fiscal and monetary spending come to an abrupt end. This will be one nasty hangover.
Markets are mostly forward looking, that is they incorporate what is known today and what is expected in the future. What we believe markets have failed to adequately reflect at this point is the likelihood and depth of recession. Profits warnings from companies are becoming more frequent and more severe and the market’s reaction to them gives signals. If the market expected bad news, then this would already be reflected in the share price and so there would be little movement. At the moment any profits warning is seeing prices tumble; markets are not expecting the negative data.
As such we remain in “batten down the hatches” mode. Our debt investments are as high quality and short duration as they can be and our equity selection is based on selecting enduring robust businesses and holding back plenty of cash/near-cash to take advantage of opportunities when they present themselves.