Investment Update – Gradually and then Suddenly

When we last wrote, in May, we suggested markets were travelling much too hopefully, ignoring the likely consequences of an historically aggressive series of interest rate hikes. Since then, the US stock market has continued its upward surge, driven not by stronger company earnings, but by investors’ willingness to pay a higher price for those earnings. Having risen 27% from its October lows, the S&P 500 is trading at a multiple of more than 20x this year’s earnings, well ahead of the ten-year average multiple of 17x. These extraordinary gains have been fuelled by optimism that, having raised interest rates forcefully in the face of high inflation, the US Federal Reserve may now be on course to engineer a much hoped for ‘soft landing’.

In the soft landing scenario, fading inflation allows the Fed to start cutting interest rates before they inflict significant damage on the economy; growth slows and perhaps some jobs are lost, but crucially recession is avoided. The implications for investors are lower bond yields – and hence positive capital returns from fixed income allocations – and equity markets that are underpinned by solid, if unspectacular, earnings growth.

The appeal of the soft landing scenario is clear. But is it credible?

After a torrid 2021 and 2022, the year to date has been much more encouraging on the inflation front. The rate of growth in US consumer prices peaked at 8.9% year-on-year in June last year, but has since drifted down to 3.1%. Admittedly, core inflation (which strips food and fuel from the calculations, two areas where prices can be volatile and driven by factors beyond the central bank’s control) has proved more stubborn, but the trend has nonetheless been downward. Furthermore, signs of normalisation in housing rents and used car prices – major contributors to the inflationary surge – suggest there is good news still to come. At the same time, unemployment remains near record lows. Wages have been rising (in nominal terms, at least) at the same time that inflation has been easing. Surely this augurs well for a soft economic landing?

Unfortunately – and perhaps predictably – we are sceptical. While we acknowledge a soft landing is possible, we think it improbable. As many, including us, have repeatedly pointed out, monetary policy works with long and variable lags: the current state of the economy says more about interest rates as they were twelve or eighteen months ago than it does about the appropriateness of today’s policy stance.

Twelve months ago, US interest rates were 2.50%. Eighteen months ago they were just 0.25%. Today they stand at 5.50% with a further quarter-point hike possible before the Fed calls it a day. The Fed’s task is far from easy. Historically, soft landings are vanishingly rare. Given the violence of the post-pandemic economic cycle, the ferocious pace of the policy tightening and the Fed’s “data dependent” (i.e. backward looking) approach under Jerome Powell, the chances of success – either by luck or by judgement – appear slight.

Rapid increases in interest rates have invariably led to recession… with a lag

We admit that we have been surprised by the resilience of the economy in the face of one of the most aggressive hiking cycles on record. In retrospect, we underestimated the endurance of the fiscal largesse enacted during the pandemic, the degree to which long-term mortgage deals would shield homeowners from the effects of rising interest rates and the extent to which inflation would support company earnings even as sales volumes deteriorated. However, we believe the inevitable has merely been delayed.

By most estimates, the stimulus cheques handed out by the US government during the pandemic enabled households to add around $1.5tr to their accumulated savings, equal to about 6% of annual economic output. These excess savings subsequently allowed many – though by no means all – households to weather the onslaught of inflation, ensuring consumption has remained a powerful engine of economic growth. However, data suggest this war chest is now close to empty, and signs of financial frailty among portions of the population are emerging. For instance, delinquencies on car and credit card loans are edging up, particularly among younger borrowers.

Unsurprisingly, banks are taking notice of the strain imposed by higher interest rates. A striking feature of this quarter’s earnings updates has been the news that US banks are already being forced to take higher write-downs on bad loans, and to set aside higher sums to cover future impairments. To try to limit the damage, they are tightening lending standards: more than one in five loan applications were denied in June, the highest rate of rejection in five years.

Meanwhile, the corporate sector is also coming under pressure. Though credit spreads (a measure of the additional yield demanded by bond investors to lend to riskier borrowers) have remained curiously subdued, the interest that companies must pay on debt has nonetheless risen sharply thanks to the Fed’s rate hikes. Consequently, companies are drawing in their horns: issuance of new high yield bonds over the first six months of the year is the lowest it has been since 2009. As debt is fuel for spending and thereby growth, its withdrawal is likely to weigh on the economic outlook.

More pointedly, increasing numbers of businesses are simply not able to bear the burden of higher interest rates. Bloomberg calculates that, globally, some $590bn of debt is either in default or distress and that bankruptcies are happening at a pace that, outside the early days of the pandemic, has not been seen since the depths of the financial crisis. We expect bankruptcy and default rates to climb steadily as, one-by-one, debts become due.

It is not particularly original to quote Hemingway at this point:

“How did you go bankrupt?”
“Two ways. Gradually and then suddenly.”

However, we think the lines that follow – and that are often left out – are also pertinent:

“What brought it on?”
“Friends. I had a lot of friends… Then I had a lot of creditors, too.”

As higher interest rates and tighter lending standards turn friends into creditors, we expect the resilience of the labour market to crumble. Unfortunately, job losses are inevitable as business models that, unwittingly or otherwise, were dependent on the availability of abundant and cheap financing are identified and exposed. Rising unemployment creates its own economic downdrafts, and so a recession begins.

Recessions begin – and accelerate – as unemployment starts to rise from low levels

 

The depth and severity of the recession depends in part on how long this process takes to play out. The longer interest rates remain high, the more dominoes are likely to fall – and the more spectacularly they are likely to do so. Seen in this light, ambivalent economic data which foster hopes of a soft landing seem much less benign.

We have for some time advised caution, reducing equity allocations on four occasions and skewing fixed income holdings towards high quality bonds which we expect to deliver meaningful positive returns in a recession. This is often the most challenging part of the cycle. In order to protect against the fall-out from the market’s excessive optimism, we have to be willing to position against it. Nonetheless our caution has at times been uncomfortable as equities and bond yields have marched higher. This discomfort is, we think, nonetheless worth enduring as we wait for the burden of high interest rates to finally make itself felt in the real economy – it is a price worth paying to make sure portfolios are well positioned when friends become creditors and the gradual becomes sudden.

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Investment Update – The Turn of the Screw

Equity markets have regained their poise after March’s mini banking crisis; UK equities have gained c4% through the first four months of the year while US equities are now c15% higher than the lows reached in October of last year. In our view, however, investors are travelling much too hopefully – not least in ignoring the growing impact of the highly aggressive and ongoing interest rate increases imposed by central banks over the last year to tackle sticky inflation. In this context, the tightening of credit availability, a consequence of serial second-tier bank failures in the US, is likely to prove a further turn of the screw – bearing down on lending, economic activity, and thereby corporate earnings. In this note we review recent developments and present the evidence for continued caution.

US Regional Banks

At a press conference following the meeting of his interest rate setting committee on 3rd May, Fed chair Jerome Powell sought to reassure financial markets that the failure of three US regional banks was a discrete and contained series of events that was now safely in the past.

“There were three large banks, really, from the very beginning that were at the heart of the stress that we saw in early March, the severe period of stress. Those have now all been resolved, and all the depositors have been protected. I think that the resolution and sale of First Republic kind of draws a line under that period.”

Chair Powell’s Press Conference 3 May 2023

As he was speaking, however, Powell must have had a keen sense that his words were rooted more in hope than reality. The share price of another regional bank, PacWest Bancorp, was plunging at that very moment, losing more than 50%. It wasn’t the only one – shares in other second tier lenders were also plummeting.

US regional banks might be considered a dusty corner of financial markets, but they are far from insignificant for the US economy. According to the FT, US banks with less than $250bn in assets (that is all banks beyond the 12 largest) provide 80% of all commercial property loans, 60% of residential real estate loans and half of the commercial and industrial loans in the US. Unsurprisingly, given the storm they find themselves in, their willingness to lend is declining rapidly. The chart below shows two readings from the latest Fed’s Senior Loan Officer Opinion Survey, together with recession bands for the US economy. It shows that banks are rapidly tightening lending standards for commercial and industrial (C&I) loans – and also that demand for such loans is declining. As can be seen, with data going back to 1990, current readings are at or close to those seen in past recessions.

Fed survey shows tighter standards and weaker demand for commercial and industrial loans

*The surveys ask senior loan officers a series of questions. Shown above are (LHS) Net percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle Market Firms and (RHS) Net percentage of Domestic Banks Reporting Stronger Demand for Commercial and Industrial Loans from Large and Middle Market Firms. The scale is from +100% (all respondents replying in the positive) to -100% (all respondents replying in the negative).

Looking ahead, given that US businesses are now labouring under the yoke of interest rates at their highest level since 2007 – and regional banks are continuing to suffer deposit outflows while enduring losses on their bond investments – it appears highly likely that the situation will deteriorate further.

Economic Data and the Recession Narrative

At such times we believe it pays to watch the economic data very, very carefully. The numbers are panning out broadly as one might expect as the dead-weight of higher and still rising interest rates progressively bears down on economic activity. Readings that have historically given early indications, most notably the outlook surveys and housing market data, have long been signalling weakness ahead. Elsewhere, inflation itself has been slow to fall back while in the labour market the picture remains, inexplicably, resilient. However, in our view the direction is set and we attribute the contradictions between leading and lagging indicators to timing. The maxim that monetary policy works with long and variable timelags, although too often quoted, remains apt; we do not believe there is much more than the remotest chance that a marked economic downturn is avoided. While there are few commentators yet prepared to say that the downturn could be very painful, to our mind this is more about not wanting to be accused of talking the economy down, rather than any genuine belief that further weakness will be avoided.

Consideration of just one economic series is sufficient, to our minds, to demonstrate this point. The chart below plots theUS Conference Board Leading Economic Index (LEI) series since the late 1960s. Once again, we include recessions as shaded areas. The LEI is constructed from ten components such as manufacturing new orders and building permits. The direction and magnitude of monthly changes in the underlying components are standardised to give the index itself. As can be seen, the index has proven a reliable indicator of recessions. The current level of the LEI is consistent with US recession. The commentary accompanying the latest data release (20th April) included the statement:

‘The Conference Board forecasts that economic weakness will intensify and spread more widely throughout the US economy over the coming months, leading to a recession starting in mid 2023.’

Flashing amber: the Conference Board Leading Economic Index is forecasting recession

Since 1970, whenever the LEI has reached the level denoted by the dotted line, a recession has followed.

Equity Markets – earnings and valuations

One of the ten components of the Conference Board’s Leading Economic Index discussed above is the stock market, as measured by the S&P 500 Index. Notably, it was one of just two of the ten that has contributed positively over the past six months. There is a striking irony here; if the stock market wasn’t holding up far better than circumstances justify, the LEI would be deeper in negative territory. To put numbers around our contention that equity markets are doing rather better than warranted, we highlight the current P/E ratio on the S&P 500 Index. It currently stands at 18.6x – almost exactly in line with the 10-year average of 18.5x. With earnings already suffering downgrades as higher interest rates start to bite into economic activity this, in our view, is too generous – especially as investors should be demanding a margin of safety at this point of the cycle, given the very real possibility that earnings could fall a long way should the economy tip into a recession.

Conclusion

Higher interest rates, tightening bank lending conditions and current valuations all suggest that investors should proceed with caution. We have not touched on the impact of the ongoing conflict in Ukraine, political risks around US-China relations or indeed the impending debt ceiling wrangle fast approaching in the US: all add to the argument that a defensive stance is warranted.

Given the above, it will come as no surprise that recommended portfolios are light on equities – with a preference for highquality companies that exhibit strong cash generation, robust balance sheets and earnings resilience – and heavily weighted to high quality bonds. We expect the latter to provide a degree of protection in the event of further equity market weakness and expect to recycle bonds into equities in due course as opportunities present themselves.

 

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Investment Update – Misplaced Optimism?

Stock markets have enjoyed a strong rally over the past four months amid optimism that inflation could fall back to target without a painful economic adjustment, despite the sharp interest rate increases implemented over the past 12 months. In this note we look behind the equity market strength to developments in some of the economic data and consider the likelihood of inflationary pressures dissipating without a significant economic slowdown. Our conclusion is that we are not yet ‘out of the woods’, and we continue to recommend caution.

The ‘Happy’ Roadmap for 2023

After last year’s precipitous ascent in interest rates in developed world economies, 2023 was expected to be all about a moderation of inflation and a resulting turn lower in interest rates. In recent months, inflation in the all-important US economy seems to have followed this script. Having surprised to the upside time and again through the first three-quarters of 2022, inflation appeared to peak and begin to fall back in October. Readings since then have mostly surprised to the downside, igniting hope amongst investors that victory was in sight in the battle to re-establish price stability so that interest rates could begin to fall, and economic growth could be allowed to safely re-accelerate once more – ushering in a new expansion phase.

Such sentiment saw equity markets consolidate and begin to move higher once more. From its October lows, the S&P500 Index of the largest US companies recovered by 16% to mid-February – halving the losses suffered by investors since share prices began their descent at the start of 2022. Bond markets were similarly cheered, with the yield on the US 10-year government bond moving down from 4.25% in late October to 3.37% by mid-January. The ‘soft landing’ scenario – where inflation drains away without impacting economic growth too much or taking unemployment meaningfully higher – seemed to be the central scenario being priced into financial assets. Hopes for a soft-landing were bolstered by an improvement in some indicators of the health of the US economy, suggesting that interest rate hikes have not sapped economic growth. Data here includes resoundingly strong new job creation, extremely low unemployment and resilient retail sales.

A Dose of Reality

We remain doubtful that such a rosy outcome is likely. While the idea of the economy remaining strong as inflationary pressures disappear of their own accord is hugely appealing to policymakers and investors alike, it doesn’t appear plausible. To believe that inflation can return to the 2% target while US unemployment is at a 50-year low, and wages are growing far in excess of a level that is consistent with this target, is simply too optimistic.

In support of this view, the latest twist in the data has seen the soft-landing narrative begin to morph into something much less cheery: a ‘no landing’ scenario. Here growth does not slow – and inflation does not fall back to target. To us, ‘no landing’ simply indicates that inflation isn’t responding to the policy measures taken to date – that the medicine of serial interest rate hikes has not been strong enough, or applied for sufficient time, to return US inflation to target. It is not a happy outcome; further interest rate increases would follow, increasing the pain inflicted on those sectors of the economy that are very sensitive to higher interest rates, such as housing. It also seems likely that higher interest rates for a longer period would increase the likelihood that when the economic slowdown does arrive, it will be of the hard variety. This, of course, will provide further challenges for investors.

In recent days this message has begun to get through to financial markets. Government bond yields have started to climb once more, with the 5-year US government bond yield rising from 3.64% to 4.19% through February (see chart). This indicates that bond investors now believe that interest rates may need to rise further – and have to stay at elevated levels for longer to force inflation back towards target. Such developments have halted the stock market rally, at least for now, with US equities peaking at the end of January.

Chart - bond yields turn higher once more amid concern that inflation may prove sticky

Last Friday, new data confirmed that optimism that inflation might ease while economies remain strong might well prove misplaced. The Personal Consumption Expenditure (PCE) measure of US inflation ticked higher once more with an annual core measure (which excludes food and energy) of 4.7% for the year to January, up from 4.6% in December. For completeness, the headline number was reported at 5.4%, again higher than expectations and higher than the December reading of 5.3% (see chart). Of course, these numbers might be a one-off, but taken together with coincident indicators of economic resilience elsewhere, investors would do well to take heed of the mounting evidence before them.

Portfolio Positioning

We have been surprised that the scale and speed of the interest rate increases across the developed world has not, thus far, had greater impact on economies and in particular, labour markets. This may be down to the much-discussed time lags in the transmission of tighter monetary policy to the real economy or possibly to changes in the structure of markets, such as that for labour, which alter the sensitivity to higher interest rates. Either way, it now seems more likely than not that the path back to 2% inflation will be prolonged and uneven – and may well involve a recession.

From a portfolio perspective, flexibility remains our watch word. We continue to look favourably on the now higher levels of income available from high quality bonds and indeed are recommending additions here, given that yields have ticked higher again in recent weeks. Aside from the yield on offer, bonds should provide a degree of protection as and when economies eventually slow under the weight of successive interest rate rises. While there is, of course, some risk that yields rise further still (bond prices fall), in our view this is becoming an increasingly asymmetrical bet – with interest rates and yields unlikely to be sustainable at higher levels in the medium term.

Turning to equity allocations, these have been much reduced from the recommended positioning twelve months ago. Within equities we continue to believe that earnings visibility and quality should fare better than the market more broadly, but we are taking advantage of recent strength in markets to reduce portfolio sensitivity to a prolonged period of elevated interest rates – as we judge the risk of such an outcome has now increased.

Finally, with regard to overall portfolio positioning, we believe that re-risking via additions to equities in due course will prove profitable and are carrying out research to identify the appropriate funds. At present, however, given the uncertainty surrounding the path of growth and inflation, and therefore interest rates, this seems premature.

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Investment Update – The Fed, Fidelity’s Magellan Fund, and Ferraris

Very few investors will rue the passing of 2022. The Financial Times headlined its final issue of the year with ‘Markets lose more than $30tn in worst year since financial crisis’. In stark contrast to the crisis of 2008 however, 2022 offered investors almost nowhere to hide, with high quality bonds suffering significant losses alongside equities, thanks to the cascade of interest rate increases imposed on economies in response to an inflation shock that built progressively over the year. With the key central bank, the US Federal Reserve, still talking tough on further rate hikes and concerns that the impact of a possible recession is not yet fully discounted in share prices, the traditional, rose-tinted outlook that greets most New Years is notably absent. In this note, we revisit a key lesson from last year, try to put some context around the derating of equities with help from Wall Street legend Peter Lynch and consider what this implies for investment markets and portfolios as 2023 begins to take shape.

The Fed

If there is one lesson we might usefully re-learn from 2022 it is that forecasting macroeconomic variables such as inflation, unemployment and interest rates is very difficult. Believing that Fed. chairman Jerome Powell had any special insight when he repeatedly stated that inflation was transitory and that interest rates would not need to increase in 2022 was a pit into which many stumbled. Despite the innumerable economists working for the Federal Reserve, Powell’s assertion proved no more than misplaced optimism. Looking ahead, this might lead us to question the degree to which we should believe his latest pronouncement – that interest rates will now need to rise further and stay higher for longer. They may or they may not, depending on the path of unemployment and inflation data from here. Powell and the Fed are ‘data dependent’, they will respond to the evidence as it evolves – especially with regard to the labour market and wage growth. We should keep this in the front of our minds as we contemplate the consensus view – that investment markets will continue to struggle. The chart below shows the extent to which equities and bonds fell last year. After such marked weakness we need to be mindful to avoid the trap of allowing past performance to colour our judgement about the future. Asset prices are now meaningfully cheaper, and we should factor that into our investment decisions moving forward.

Fidelity’s legendary manager

Our Christmas-break reading included revisiting one of the great books on investing, One Up on Wall Street by Peter Lynch. Lynch was the celebrated manager of Fidelity’s Magellan fund in the 1970s and 80s. He achieved returns of close to 30% p.a. over 14 years until his retirement in 1990. We were struck by his humour and clarity of thought, particularly about what he could and couldn’t do as an investor. With regard to equity markets, his straightforward but very helpful insight was that, while he had no idea at all whether the next 1,000 point move in the stock market would be up or down, he knew with some certainty that the next 6,000 points would be up. His logic is simply that the short-term volatility of the economy quickly becomes irrelevant, while corporate earnings grow over time – and share prices move higher to reflect this fact. This is useful not only when putting last year’s weakness into context, as discussed above, but also when digging into individual stocks:

‘I don’t think people understand there’s 100% correlation with what happens to a company’s earnings over several years and what happens to the stock’.

It forms part of One Up on Wall Street’s repeated focus on the obvious, but seemingly often ignored fact that behind every stock there is a company, and an investor must know what they own. This brings us to our next section – on the sorts of stocks we prefer at this time of great uncertainty.

Ferrari

We were struck by a CNBC article late last year reporting, in a surprised tone, that despite surging fuel prices, rising ESG concerns and the hype surrounding electric vehicles, the best performing car manufacturer in 2022, in share price terms, was Ferrari.

Truth be told, the hurdle was not high. Ferrari shares declined by c15%, compared to most of the start-up electric vehicle manufacturers losing c75% of their market value, and volume car makers such as GM and Ford losing c40%. In fact, one might have hoped for better from the shares of the Italian sportscar maker. The chart below illustrates perfectly the Peter Lynch quote – the Ferrari share price has closely followed the company’s earnings growth since its flotation as a standalone company seven years ago. At least it did so until late in 2021. Since then, earnings have continued to grow but Ferrari shares have fallen back.

Is the recent divergence of the company’s share price from its earnings noteworthy? What is the correlation breakdown telling us? In our view, nothing at all. The fall has been part of a general de-rating of equity markets as higher bond yields began to offer investors attractive levels of income for the first time in 15 years – and analysts used higher interest rates when calculating target share prices for equities. The latter simply resulted in lower ‘theoretical’ share prices for all companies – but particularly those faster growing companies trading on higher PE multiples. How do we know that the share price is not signalling declining earnings ahead? Of course, we cannot be certain, but we do know that as recently as November Ferrari raised its profit guidance for 2022 and stated that it foresaw no problem with demand in 2023, regardless of the economic conditions. In our view, Lynch’s 100% correlation will reassert itself in due course.

Moving from the specific to the general, charts for many of the largest holdings in our recommended portfolios look similar; at this juncture we prefer to own high quality companies that possess a history of delivering consistent earnings growth through the economic cycle. Below we share just one more example, LVMH, the French luxury goods company. It too has suffered a derating despite continued earnings growth. Sooner or later, as long as the business model remains intact and management continue to execute, the share price should catch up – and track higher along with continued profit progression. The key point is that the strong underlying business economics of such companies mean that they are largely insulated from the short-term ups and downs of economies and interest rates. The appendix displays the impressive 5-year annualised total return and earnings per share growth for the 10 largest underlying equity holdings in our recommended portfolios.

Portfolio characteristics

As 2023 gets underway, the range of possible outcomes for investment markets appears extraordinarily wide. A positive year for equities and bonds is entirely possible should inflationary pressures ease more quickly than currently assumed. At the other end of the spectrum, inflation and wage growth could remain stronger for longer – leaving the Fed with little choice but to continue hiking interest rates. This would most likely result in another year in which markets struggle. Other factors will also, no doubt, come into play, not least the Russia-Ukraine war and its continued impact on energy prices but also, for example, the path of China’s reopening and possible changes to Japanese monetary policy. Clearly, there is plenty to concern investors, however, as noted above, equity markets have endured a reset and valuations are now much more attractive. This is also the case in bond markets, where yields are now more attractive than they have been for over a decade.

As a result of this heightened uncertainty, recommended portfolios are positioned for flexibility. Allocations to cash and short-dated bonds are included to provide yield and defensive characteristics while the equity allocations, much reduced through 2022, are skewed towards the types of companies discussed above – those with strong business models which should prove resilient to short term volatility while also having the potential to participate in the upside when the macroeconomic picture brightens. Should the likelihood of the latter increase, holdings of defensive assets give us the flexibility to rebuild risk asset positions to capitalise on an economic upturn.

Appendix

The ten largest equity holdings within Heronsgate Capital Model portfolios:

Source: Refinitiv
Stocks Annualised Return, 5 Year (%) Annualised EPS Growth, 5 Year (%)
Microsoft 24.2 24.1
Mastercard 18.4 12.6
ASML 30.3 27.7
LVMH 24.2 18.2
Novo Nordisk 25.4 10.1
TSMC 18.2 24.8
Lonza Group 12.2 2.0
Alphabet 11.1 28.5
Ferrari 15.8 9.6
Cadence Design Systems 30.9 24.4
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Investment Update – From Inflation to Recession

Leading indicators of growth for the US economy are now pointing to marked weakness ahead. In stark contrast, readings for inflation and employment (both lagging indicators) are still too ‘hot’. In response to the latter, over the last nine months we have seen one of the most aggressive US interest rate tightening cycles in history. Price stability will eventually be achieved – but this is likely to come at a high price in terms of employment and output. In this note we review how economic developments have shaped markets in 2022 and begin to explore how the investment landscape might look in 2023.

It seems likely that 2022 will end up in the stock market history books for all the wrong reasons. As the year began, the consensus view was that US interest rates were likely to rise gradually from the emergency support levels that had been in place since the pandemic. At the time, US (CPI) inflation stood at 6.8% but this was attributed to what Fed chairman Jay Powell now famously described as ‘transitory’ factors: changing consumption habits driven by lockdowns, combined with disruption to supply chains. Both were expected to quickly dissipate, with Powell even going on the record saying, ‘We’re not even thinking about thinking about raising rates’. This proved to be very, very wide of the mark. As the year unfolded, inflation proved to be far from transitory and borrowers have had to endure a torrent of interest rate hikes. What was expected to be a maximum of around three 0.25% interest rate rises back in January has turned, by mid-November, into four successive 0.75% hikes – with US interest rates now in the 3.75-4% range. This is up from the 0-0.25% range that was in place until the first rate rise in March. There are more to come.

As a result, bond prices have been squashed. Equity markets have declined in sympathy, driven initially by the higher interest rate applied to discount the value of future earnings and more recently by the weaker outlook for profits as the economy slows under the weight of much tighter monetary policy. This ugly combination earns 2022 its place in history as one of only four years in almost 100 years where both equity and bond prices have fallen in tandem (see chart). The Bloomberg Global Aggregate Bond Index has dropped by 17% over the year to date, while the S&P500 broad US equity index has declined by 16%. We now consider 2023. Is there any relief in sight?

US Stock and Bond Returns 1928 - 2022

2023 Outlook

Next year is likely to be challenging for the global economy. The IMF’s October 2022 World Economic Outlook highlighted its expectation that more than a third of economies will be in contraction in 2023, with the three largest economies, the US, the EU, and China all likely to stall. Closer to home, the Bank of England’s (BoE) most recent forecasts suggest that the UK economy is already shrinking, and that it will continue to do so for another eighteen months, making it the longest recession in 100 years. These forecasts accompanied the BoE’s largest interest rate increase in more than 30 years. This is remarkable. In most cycles interest rates are increased as the economy strengthens – to head off nascent inflationary pressures. This time, because central banks were caught out by the magnitude of the inflation shock, interest rate increases are taking place into a weakening growth backdrop. This disconnect is vividly illustrated in the chart below. It shows the path of ISM Manufacturing New Orders in the US against the one-year change in 5-year US government bond yields. In essence it shows that, in the past, when the business outlook is improving bond yields tend to be rising, and vice versa. This is logical – but it’s not what is happening now. At present the business outlook, as measured by the historically reliable new orders component of the ISM survey, is deteriorating rapidly while bond yields have increased sharply.

Figure - Business outlook diverging from interest rates: something’s got to give

The explanation for the disconnect is high inflation, and the sharp interest rate hikes implemented to address it. However, with many leading indicators pointing to weakness ahead, deteriorating economic fundamentals are now working in the same direction as tighter monetary policy, bearing down on inflation. One notable leading indicator is housing. Housing market activity in the US appears to be grinding to a halt under the weight of 30-year mortgage rates which have moved from 3% to more than 7% in 12 months. This is the fastest pace of increase in forty years. This sector is important as one of the stickiest components of inflation is ‘shelter’ which measures home ownership and rental costs. This is still climbing, perhaps because people are deferring house purchases in the face of much higher mortgage costs. However, given a rapidly weakening housing market and pressure on consumers from higher prices elsewhere, inflation from this source seems highly likely to fall back in due course.

Housing is also important because the construction sector employs close to 5% of the US labour force, therefore along with related supply and service businesses, housing accounts for a great deal of employment. Unsurprisingly, jobs are now being lost in these areas and it seems likely that this will gather pace. A quote from a recent FT article highlights the extent of the impact of higher interest rates:

‘Realtors, mortgage brokers, appraisers and construction groups say they have lost as much as 80 per cent of their revenue since the Fed started raising rates in March.’
US property sector braced for job cuts as rate rises crush home sales FT 11.10.22

Returning to inflation, the time lags involved in the transmission of higher interest rates to the real economy suggests that it will not turn on a sixpence, but, driven by ongoing increases in interest rates and a deteriorating economic backdrop, the direction appears firmly set. Importantly, Jay Powell recently pointed out that medium term inflation expectations remain well-anchored. This means that, in sharp contrast to the 1970s, continued, rapidly rising prices are not yet built into the psyche of consumers and businesses. This suggests that, with the appropriate central bank action, very high inflation should not prove a long-lived challenge.

Portfolio Positioning

Turning to portfolio positioning, financial markets are forward looking and so have discounted at least some of the difficulties ahead. However, we remain concerned that an overzealous Fed, fixated on lagging indicators such as employment and inflation, will drive the US into a recession or trigger a crisis in financial markets or other areas of the economy before it stands down from its war on inflation. We have therefore positioned portfolios cautiously – in accordance with what the leading indicators are signalling about the months ahead. High quality bonds would usually be a haven in such circumstances but have certainly not been the place to be so far this year. We were too early to add here but remain convinced that they are very unlikely to inflict defaults on investors. Also, they now offer significant yields and, more importantly, should provide protection should the US economy really start to show the effects of the continued, eye-watering tightening of financial conditions. Elsewhere, equity allocations are much pared back and focused on large cap, quality businesses that we believe will prove resilient in the face of economic weakness. Portfolios are, in summary, on a recession footing. However, as we move into 2023 the investment outlook should become progressively more positive. Inflation will be easing, and markets will begin to look beyond the economic weakness to the recovery. After the sharp corrections seen this year, there are likely to be attractively priced opportunities for investors.

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Bonds – why bother?

According to the Wall Street Journal, 2022 thus far has been the worst year for US government bonds since 1842. Other bond markets have fared no better. The driver has been a complete turnabout in the inflation, and therefore the interest rate, landscape. Investors have demanded higher yields on bonds – driving prices down. After such falls, and with interest rates continuing to rise to address what looks like a stubborn inflation problem, investors should quite rightly be asking themselves why they are bothering with bonds at all. In this note we look to answer this question by considering the economic outlook and the possible path of inflation, interest rates and bond yields from here.

However, we begin with some bond background.

 

Bonds

Bonds warrant a place in portfolios because of their reduced correlation with riskier assets, the low volatility they typically exhibit, and the return above cash they usually provide. They ought to be straightforward. A simple, fixed annual coupon is paid on the capital sum borrowed, with that sum repaid on the agreed maturity date. Even greater simplicity is achieved if the bond is issued by a government which, being able to issue more currency to repay it, is highly unlikely to fail to pay the coupons or repay the capital. There is effectively no default risk. The challenge comes with the erosion of purchasing power of the cash sums, returned via coupon and capital, by inflation. If inflation is diluting away the purchasing power of bond holders, they demand compensation – in the form of higher coupons on new bond issues. Those bonds already in issue fall in price – so that they offer a yield competitive with new bonds issued with higher coupons. This is the simplest of explanations for recent bond market weakness. It is important to note, however, that these falls in bond prices do not mean that the flow of payments from the bond will decline or stop altogether, only that the bond prices have fallen to reflect the higher yields demanded by investors. We now consider the experience of bond markets this year and the underlying economics.

Bond woes, economics and the path ahead

This year’s bond market woes were triggered by the surge in inflation which began late last year, and the increasingly aggressive interest rate tightening cycle pursued by central banks to address it. It now seems likely that by the end of the year, US interest rates will be around 4%. As recently as March they were zero. Interest rate increases of this rapidity and magnitude are beyond extraordinary and with more interest rate increases to come, surely investors should be confining bonds to the bucket labelled ‘not with a barge-pole’?

Before attempting an answer to this question, we should issue a mea culpa. We did not believe that inflation would, or could, become the issue that it has. Along with many central bankers, we were in camp ‘transitory’, believing that the inflationary impulses – the product of covid-related supply disruptions – would pass through the global economy without leaking into other areas. In taking this view, we were not unthinkingly following the central bank line. Our rationale was based on the fact that, after a very long period of very low interest rates, the world economy had become very, very indebted and would therefore be extremely sensitive to higher interest rates. To us this meant that faced with rising rates, economies would slow very quickly – easing inflationary pressures and removing the need for interest rates to go up far, or for long. In short, we believed that small interest rate increases would trigger slowdowns which would ‘cure’ any inflation and allow interest rates to fall back again. Anything else would spell great difficulty for consumers, companies and governments alike.

So much for that theory. Inflation remains stubbornly high – forcing central banks to impose the enormous interest rate hikes we’ve seen in recent weeks. Despite this, so far labour markets have remained strong, wages are growing and, as we write, a report has been issued by the UK’s Office of National Statistics showing that house prices rose by 15.5% in the 12 months to the end of July.

So, is it the case that ongoing interest rate increases are fully warranted – and inflation is not going to fall back any time soon? If this were the case, bonds should definitely be avoided. While this narrative makes sense on first inspection, we do not believe it is correct. Beneath the surface, higher interest rates are already hurting economies – and the pain has barely begun. Housing markets are souring. The share prices of UK house builders have halved this year while in the US, mortgage rates are now 6.4%, much more than twice what they were a year ago. Unsurprisingly, given higher mortgage rates are being charged on much bigger mortgages, forward looking housing market metrics are swooning. Many other indicators are flashing warning signs and sentiment indicators and surveys are slumping. Lagging indicators including employment, and indeed inflation itself are, we believe, set to follow. The chart below shows the historic correlation between the NAHB index, a US housing market outlook survey where readings below 50 indicate a poor outlook, and the US labour market 18 months later. The relationship is extraordinarily clear. It suggests much higher unemployment in the coming months.

Bringing the discussion back to bonds, yields have already risen significantly to reflect the further interest rate rises that central banks are expected to deliver. The economic landscape set out above suggests that the high point for bond yields is nearing. Bonds do well when interest rates are falling – this tends to occur when the economic outlook is poor, because the secure coupons paid by government bonds are attractive relative to the alternatives. In our view, the outlook is indisputably poor. The rapidly deteriorating economic environment is the reason that we have put through significant cuts in equity weightings. It is also why we are trying to be patient with bonds. They are paying coupons and offering yields far higher than was the case a year ago – thus there is some compensation for our patience. High-quality government and corporate bonds will also typically repay the borrowed capital sum in full upon redemption (default rates over the last 40 years have been inegligible).

Our second chart shows a brief history of the relationship between interest rates, inflation and recessions. Interest rates are increased to deal with, or head off, rising inflation. Higher interest rates slow the economy, often to the extent that it enters a recession (shown as the shaded areas). When the inflation dragon is slain, interest rates are then cut – and a new economic cycle begins as growth resumes.

In short, bonds are now offering investors with increasingly attractive levels of income as an alternative to riskier assets. As we have reduced our exposure to equities in light of the deteriorating economic backdrop, we have, for now, been increasing our allocations to bonds to take advantage of these more attractive yields. Some of the short-dated bond funds that populate portfolios are offering investors an income of c4%. Meanwhile, with central banks resolutely focused on bringing down inflation by slowing their economies, many of the fund managers and economists we meet see good value in fixed income, with high-quality bonds likely to prove defensive amid an environment of sustained economic weakness.

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Cause for Caution

Share prices have rallied strongly from their mid-June lows giving us the opportunity to lighten equity allocations further. We remain cautious, and this is reflected in our recommended portfolio positioning. We have been surprised that the more positive mood has persisted into August; equity markets have now regained more than half of their losses from earlier in the year. In this note we look at the possible explanations for the mid-year equity market rally, revisit the case for caution and outline what we believe may unfold over the remaining months of 2022.

The rally

The lows for equities this year came towards the end of a tumultuous first half. Mid-June saw US equities, as measured by the S&P500, fall to a low point of 3,666, almost 25% below the level reached at the start of the year. Since then, that index has recovered by more than half, leaving it only a little over 10% lower in capital terms for the year thus far. In the face of steeply rising interest rates and a deteriorating economic backdrop, this, in our view, is remarkable.

We have come across three possible explanations: (i) building optimism that the pace and extent of further interest rate rises may be limited, (ii) a belief that the extreme market weakness of the first half of the year was overdone in light of a better than feared second quarter earnings season from companies and (iii) ‘technical’ factors, whereby momentum investors and hedge funds, which were positioned for further weakness, have been forced to buy back short positions as risk assets rallied. As fundamental investors with little insight into the positioning of traders, we restrict ourselves to commenting in detail only on the first two drivers.

(i). The equity market rally began on 16 June. It is not a coincidence that this was the day after the US central bank, the Federal Reserve (the Fed), surprised markets with an outsized 75bp interest rate increase. This increase, in turn, was the response to a shock inflation reading the week before, with prices rising by 1% in a single month and 8.6% over one year. Bond and equity markets welcomed the Fed’s aggressive response as a commitment that inflation would be brought under control, and that a short, sharp monetary policy shock would re-establish central bank credibility. More recently, marginally better news on inflation has given investors hope that, with interest rates perhaps not rising much further, an economic slowdown can be avoided – further underpinning the rally in equity markets. The chart below shows why, in our view, this rosy scenario is almost certainly much too optimistic.

The chart shows that in previous inflationary episodes, interest rates have had to rise above the rate of inflation to bring the latter back under control. As can be seen, we are currently some distance away from this, suggesting that the Fed has little choice but to continue to raise rates. A related observation from the chart is just how serious the current inflation challenge is in the context of recent history. We have to go back 40 or more years to see inflation higher than the present level – and while we don’t expect interest rates to reach the heights of the 1980s, neither do we expect good news on this front in the near future. This is because price increases are now evident in core elements of inflation, including the key shelter component which captures the cost of accommodation. Such elements are likely to require a prolonged period of higher interest rates to get them moving lower.

In past inflationary episodes US interest rates have always risen beyond the level of inflation

In past inflationary episodes US interest rates have always risen beyond the level of inflation

(ii). The second justification for recent stock market resilience has been the continued strength of corporate earnings. To be fair, the second quarter US earning season was okay – with aggregate year over year growth of 6.7% according to FactSet. We note, however, that the earnings of energy companies made up a major part of the growth – with this stripped out, earnings declined by 3.7%. Our main observation here though is that corporate earnings lag developments in the economy by several months. A reporting season that covered earnings up until 30 June is now largely historic. As has been noted many times, stock markets are forward looking. At present, the expectation is for continued earnings growth in the coming quarters. This is, in our view, far too optimistic.

The chart below shows the strong correlation between the manufacturing outlook survey produced by the Institute of Supply Managers and the ratio of corporate earnings upgrades to downgrades. With the former likely to continue declining rapidly, this would suggest significant earnings downgrades lie ahead. Elsewhere, many of the other leading indicators that we follow also suggest that a substantial further slowdown in economic activity is looming. So, while second quarter earnings exceeded expectations, as the weight of tighter monetary policy bears down on economies, we are concerned that earnings downgrades will increase markedly, with actual future earnings materially disappointing.

Forwards looking surveys are heading lower – corporate earnings tend to follow

Forwards looking surveys are heading lower – corporate earnings tend to follow

 

Finally, we consider very briefly ‘technical’ factors. As stated above, we have no special insight here. We can, though, accept that following the brutal falls in share prices from the start of the year until mid-June, equity markets were due a pause. The argument that many traders and speculators who were betting on further declines had to cover ‘short’ positions, as markets rallied, seems plausible to us. Importantly though, as fundamental investors, we should not allow ourselves to be blown around by short term moves – however surprising or unjustified they may appear. The outlook for the economy and earnings was poor in mid-June and remains so now – a recovery in share prices doesn’t change this. It can, however, provide an opportunity to adjust portfolios. As mentioned above, we have taken advantage of this by reducing risk exposure further.

 

Looking ahead

We continue to view the prospect for equity markets in the next few quarters as highly challenging. Leading indicators are increasingly pointing to contractions in developed economies later in 2022 and 2023. This is a very unfavourable backdrop against which to be rapidly increasing interest rates but, as Bank of England Governor Andrew Bailey admitted earlier this month, despite the UK economy heading into recession, interest rates have to continue to go up to bring inflation to heel. As we write, market expectations are for UK interest rates to more than double in the coming months, having already moved up from what was effectively zero to 1.75%. The time lags involved in the transmission of monetary policy changes to the real economy are usually estimated at between nine months and a year. This means that the full weight of tighter policy is yet to be felt – here, in the US or elsewhere.

Finally, on equities, the fundamental props to rising share prices are economic growth (and thereby corporate earnings growth) and steady or falling interest rates. The latter supports or increases the present value of the future earnings that are reflected in share prices. Both props are conspicuous by their absence at present. This is the underpinning of our cautious view.

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Central banks give Investors nowhere to hide

For the first time since the 1980s western economies have a real inflation problem. In looking for explanations many will blame central banks and governments for the overgenerous support packages put in place to address economies that had come to a standstill thanks to covid lockdowns. The central banks in turn may point to unwieldy supply chains which caused price surges in a small number of goods where production was interrupted. To this we can add more recent supply disruptions due to China’s zero-covid policy, and of course the Russia-Ukraine conflict’s impact on energy prices. Finally, changes in labour markets (the Great Resignation) and the transition to net-zero should also get a mention as factors contributing to the inflationary mess that the global economy now finds itself in.

For investors, the key fact is that, for the first time since the financial crisis, central banks are the enemy. That old cliché, ‘don’t fight the Fed’ has taken on a new, malign meaning. Serial interest rate increases to re-establish policy credibility and head off the highest inflation in forty years have driven bond prices sharply lower. This has impacted both the valuation basis for equities, and more recently, the corporate earnings outlook as it has become increasingly clear that the removal of so much policy support in a short time span is likely to lead to sharply slowing growth – or even recessions. As a result, as we approach the halfway point of the year, both equities and bonds have been hit hard, making this bear market in some ways more painful than the financial crisis. There has been nowhere to hide.

Our response to these developments has been to recommend cuts to equities and to shorten the interest rate sensitivity of our bond allocations. Despite these changes, portfolio values have been hit in the near-term. The ‘right’ places to be positioned in 2022 were those areas largely shunned in the prior two years including, of course, the energy producers. We have been underweight this sector as the outlook prior to the Russia- Ukraine conflict looked so unappealing. Notably, we see that even these areas are now coming under pressure as investors’ focus moves on from seeking out inflation hedges to finding areas resilient to an economic slowdown.

Looking ahead, we have three observations:

  1. Allocations to high-quality, growing companies in our recommended portfolios have been very unhelpful thus far this year as valuations here have been compressed by rising bond yields and profit taking. We believe that this trend is likely to reverse in due course as investors begin to focus on the excellent earnings resilience of such businesses in light of a rapidly deteriorating economic outlook.
  2. Having risen at an unprecedented pace, bond yields are likely to be close to their top; as the economic slowdown takes hold, investors should increasingly see value in bonds offering yields far higher than has been the case in recent years.
  3. One silver lining is that, although our programme of portfolio de-risking has been interrupted by the pace and severity of the correction, substantial allocations to defensive assets such as short-dated and inflation-linked bonds give us ammunition to put to work in now attractively valued risk assets in the coming weeks.
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Economics, Policy and Markets in Conflict

Last December we wrote, ‘we view the prospects for 2022 as somewhat less cloud-free than 2021’. As understatements go, that might be eligible for a prize. Even before Russia’s invasion of Ukraine, life was showing signs of getting much more difficult for investors. If 2021 was a stroll in the park, this year has been an expedition up the north face of the Eiger. In this note we briefly outline the issues and explore why markets have reacted as they have. We then explain our actions to date and what we expect for the remainder of the year.

The Issues

1. Inflation

Our sense that investment markets were going to get trickier dates back to November 2021 when it became evident that
the world economy had developed a nasty dose of inflation alongside its post-covid recovery (Figure 1). In an absurdly short interval, policymakers’ view of inflation went from benign neglect to compulsive obsession. The parallel might be with a doctor changing his prognosis from, ‘you’ll be fine in a couple of days’ to, ‘I suggest you update your will as soon as possible’. In the all-important American economy, we went from being told by the US central bank (the Fed) to expect no interest rate increases at all in 2022 to, most recently, an expectation of nine quarter-point hikes, or their equivalent, this year alone. This is the fastest pace of tightening this century and arguably the fastest policy about-turn ever.

 

Wasn’t it obvious that inflation was likely to prove a problem? Clearly not to the Fed – or to the bond markets. Both adhered to the view (as did we) that covid had boosted the demand for some goods and flattened it for some services but that time, and the super-competitive nature of the global economy, would sort this out in due course. It now looks likely that the authorities in western economies badly over- egged the pudding in terms of overly generous monetary and fiscal support to address the covid-related economic dislocation. As we witnessed in 2020 and 2021, this had the effect of sending assets prices soaring. Unhelpfully, we can now see that it also meaningfully changed workers’ wage expectations and embedded rising prices into the wider economy.

So, higher interest rates were on the cards as 2022 dawned. However, the real challenge since, and the issue that has triggered so much volatility in markets, is that the Fed is now scheduling aggressive interest rate rises into what appears to be an already slowing economy. Fed chairman, Jay Powell, is pleading that the US economy is strong enough to withstand higher interest rates. Investors suspect it cannot – and, in reality, Mr Powell has little credibility in making such claims. The inflation genie is out of the bottle, and he has to get on with the job of putting it back in. For now, the Fed’s unequivocal focus is on achieving a return to price stability, irrespective of the subsequent impact serial interest rate hikes may have on consumers, corporations and economic growth.

2. Russia and Ukraine

Russia’s invasion of Ukraine is, first and foremost, a humanitarian tragedy. Additionally, from the central banker’s perspective, it makes the growth/inflation challenge much, much worse. Energy prices have risen sharply in response to actual and potential supply disruption – as has the price of wheat and a multitude of other commodities key to global supply chains. These challenges will stretch into the medium term with, for example, the disruption from western Europe ending its reliance on Russian energy likely to endure for years rather than months. In short, Mr Powell’s job of bringing down inflation, without collapsing growth has become a whole lot harder.

3. China

China’s zero tolerance covid policy, which seemed so successful early in the pandemic now looks, at this stage of the pandemic, to be misplaced. Widespread total- lockdowns are damaging the economy. Interruptions in the flow of manufactured goods from China also, of course, further exacerbate supply chain dislocations – adding more inflationary pressures to importing countries’ economies.

Separately, under the banner of achieving common prosperity, the Chinese authorities have been busy imposing greater regulation in several areas of their economy. They were unhappy with the power of some of the new internet companies, with rising property prices and access to education and healthcare. In short, they do not believe that the benefits of China’s strong growth are being distributed fairly. Their measures hit some businesses very hard, for example Alibaba, the e-commerce platform once valued at almost $1trn, has seen its share price fall by close to three- quarters. Understandably, international investors have begun to question whether they had not hugely underestimated the risks of investing in Chinese stocks.

How have markets responded to these issues?

As we’ve written elsewhere, very low interest rates are catnip for asset prices. Unsurprisingly, the opposite is also true. The extraordinary recovery in stock markets from March 2020 onwards (long before vaccines had been developed to address the virus) was driven by interest rate reductions along with increases in the quantity of money (QE) and fiscal support for consumers and companies. At the beginning of the year all were due to go into reverse. Now, however, Mr Powell’s volte-face in response to the continuing inflation surprise means that this reversal is no longer likely to be gradual and pragmatic. Increasingly, markets are facing up to the prospects of a greater number of rate hikes being delivered more quickly – and the slowdown in growth this is likely to bring. As a result, Equity markets have had a torrid time in 2022 thus far.

However, there is a more malign thread here. Low interest rates tempt companies and consumers to take on debt. If they take on too much or misjudge the pace or magnitude
of future rate hikes, they are rarely able to simply pay down the debt – some companies default or need to reschedule payments. For individuals, credit card defaults rise, or mortgage payments are missed. We have been amazed to watch the US mortgage rate balloon from 2.7% to 5.6% in a matter of months, with little commentary on what this might do to consumer spending, or indeed the housing market. In short, debt is easy to take on when interest rates are low, and difficult to shed as they increase. We suspect that lurking in corners of the financial system, perhaps in private equity, high yield bonds or leveraged asset backed funds, there are structures which will not be able to survive a prolonged period of higher interest rates. The fact that the world is now much more indebted underpins our (admittedly much too optimistic) presumption that interest rates could not rise far – as they would cause overleveraged consumers and companies to quickly keel over, producing a deep recession or prolonged period of stagnation.

In our view it is growing concern regarding the latter that is now rattling equity markets. In recent weeks, a nasty correction in share prices is threatening to morph into a full-scale rout. Investors fear that the conflict between (i) central banks, determined to squeeze out inflation through aggressive rate hikes, (ii) an already slowing economy and (iii) a heavily indebted financial system, will not end well.

The experience of bond markets this year requires comment as, in our view, it provides a clue as to what happens next. At the start of the year government bond yields rose steeply as investors demanded higher yields to compensate them for higher inflation and rising interest rates with little concern about the likely impact on economic growth. As faster, larger interest rate increases came into view, the pace of the bond market sell-off quickened. By early May the key US 10-year Treasury bond, was yielding 3.12% – more than double its 1.5% level at the start of the year. This is an extraordinarily sharp move –with bond prices falling as yields rise, investors have suffered significant losses on their fixed income holdings as well as their equities (Figure 2). Thanks to inflation, and the response from central banks in terms of aggressive increases in interest rates, bonds have not proven to be the haven investors expect them to be in volatile times.

 

In response to rapidly changing interest rate expectations, currency markets have also been highly volatile. As the Fed has ramped up its rate hiking rhetoric the appeal of the US dollar has increased. Other central banks have less scope to raise interest rates, making the US dollar relatively more attractive. For example, Japan has little by way of inflation and so no need to increase interest rates. In continental Europe (and indeed the UK) the proximity to the war in Ukraine and the resulting impact on energy supplies, and therefore growth, make substantial interest rate increases much less likely. As a result, investors have flocked to the US currency preferring higher interest rates, a comparatively stronger economy, and the safe haven status of the world’s reserve currency. The US dollar has appreciated hugely. Over 2022 to date, it has gained almost 10% against sterling, close to 9% against the euro and over 12% against the Japanese yen.

Action taken – Portfolio repositioning

Last December, in accordance with our view that the investment landscape was likely to be more challenging, we began to de-risk portfolios, selling one of our strongly performing core global equity funds and reinvesting into a fund with the flexibility to adjust its equity exposure and invest in other asset classes.

In March, in response to bond yields that seemed at risk of rising far further than we had believed likely, we switched our long-dated corporate bond fund into a short-dated counterpart. The latter, thanks to the sharp repricing of short- dated bonds, now offered an attractive yield with far less capital risk if, as has turned out to be the case, bond yields continued to rise.

Finally, last month, we took advantage of what we regarded as an inexplicable and unjustified rally in equity markets through March to remove another global equity fund from portfolios. This time, the proceeds were split between more short-dated corporate bonds and a strategic bond fund which, in our view, has the potential to add value with bond yields already at elevated levels.

What next for economies, policy and financial markets?

For a dozen or so years central banks tried and failed to generate the modest level of price increases required by their mandates. Armed with this knowledge, in 2020 they went all out to support the lockdown-ravaged economies. This time they succeeded in creating an inflation monster. They now accept that this must be tamed over the coming months and years. It will be achieved through a rapid reversal of the policy accommodation doled out in 2020, and as much further tightening as is necessary. Fed chairman, Jay Powell, would love us to believe that this can be accomplished without economic pain. In truth, he has made a dreadful mess of monetary policy – and has little option but to move ahead with interest rate increases and hope for the best on growth.

Regarding financial markets, we believe that equity and bond markets are speaking different languages at present. As mentioned above, the huge increase in yields suggests that bond investors remain optimistic that economic growth can endure, despite much higher interest rates. By contrast, investors in equities have come to the view that economic growth will slow, bearing down on corporate earnings and making equities less attractive relative to other assets.

Our conviction is that the equity market is right; economic growth, even in the US, will slow sharply from here. We believe this is already showing up in the data. This suggests that Mr Powell will not get far into his interest rate hiking cycle before he is forced to pause by weakening growth. At this point, the inflation challenge should ease, as pricing power among workers and firms evaporates, and bond yields should fall back as assumptions about how far interest rates need to rise are revised lower.

Considering where portfolios should be positioned for the months ahead, unsurprisingly in light of the above, for now we remain cautious. We are undertaking a fresh review of the equity and bond holdings underlying our favoured funds with the aim of re-examining their resilience in the face of a weakening economic picture. We are also mindful that valuations have moved meaningfully and that it is almost always wrong to become more cautious as markets fall. Finally, we are drawing up watchlists of areas of interest. There are likely to be opportunities to add back to risk assets later in the year.

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Ukraine/Russia

The situation in Ukraine has become extremely serious. Our thoughts go out to all those suffering in the conflict.

This note provides a brief comment on some of the economic and financial market developments of 2022 to date and revisits the positioning of our recommended portfolios. The headline is that investors, having started the year believing that economic growth would remain robust despite rising interest rates, now must contend with an energy price shock bearing down on the growth outlook and adding further upward pressure to inflation. We remain of the view that growth will be prioritised over inflation and therefore expect interest rate increases to materially undershoot current expectations. In this scenario, despite its short-term appeal, cash has no place in portfolios. We continue to focus on the medium term – with an eye to protecting against further near-term shocks – while looking for opportunities to add to areas which become attractively valued.

Economic Background

Even prior to Russia’s invasion of Ukraine, markets were becoming increasingly volatile. The key driver of this volatility was the abrupt change in the outlook for monetary policy.
At the very end of last year, Jay Powell, chairman of the Federal Reserve, blinked when confronted with a series of inflation readings that exceeded forecasts. Almost overnight, his policy stance changed from one of patiently waiting for the lockdown-related increases in consumer prices to pass through the system, to becoming acutely focused on resetting inflation expectations with a series of quick-fire interest rate increases. This had driven a fierce rotation in equity markets, with investors, for the first time in several years, shifting towards stocks that would benefit from a higher interest rate environment and continued robust economic growth. As part of this shift, government bond yields charged higher as expectations built for a rapid tightening of monetary policy. We resisted following the herd. Our conviction remains that growth will not endure for long in an environment of sharply higher interest rates – and that it would be unwise to reposition towards beneficiaries of economic growth or higher rates (such as commodities and banks) if there was a risk that this would prove short-lived.

Such was the situation when Russia invaded Ukraine on 24th February. The economic response from western governments has been rapid and aggressive. Following the implementation of sanctions, what had initially been an issue of supply disruption for energy, materials and other commodity markets became even more serious, with energy users facing the possibility of going without Russian oil and gas supplies for a prolonged period, perhaps even permanently. Unsurprisingly, the result has been a huge jump in energy prices. This will inevitably bear down on economic growth, as business and consumer spending is diverted into meeting these higher costs. JPMorgan estimates that were oil and gas prices to remain at current levels it would be equivalent to an additional tax of €550bn on European businesses and consumers – equivalent to 4.5% of eurozone GDP. Hence, the consensus outlook has changed quickly from one of stronger growth but higher inflation, to slower growth but even higher inflation – at least in the short term.

 

Considering investment markets, the result of war, spiking energy costs and a sharp increase in risk aversion has been marked weakness in equities. At the extreme, Russian companies have been excluded from the global economic system and their stock market remains closed; Russian stocks, including those listed in London, have effectively become worthless. Elsewhere, it has been a case of the further away from conflict the better. Europe has fared poorly, as have emerging markets. At the other end of the scale, the US, being less exposed to Russian energy supplies, has fared better. Considering sectors, banks and other financials, a favoured area through January, have been particularly hard- hit as the quantum of likely interest rate increases has been pared back. By contrast, as one might expect, the energy and resource sectors have been strong (see below).

In fixed interest markets, government bond yields, having marched relentlessly higher through January and early February, have failed to make further headway, though with some interest rate increases still on the cards they have not retraced much of their earlier increase. Another beneficiary of risk aversion has been the US dollar, a traditional safe haven in times of financial market stress.

 

Portfolio Positioning – Defensive assets

Broad diversification within our fixed income allocation has served us reasonably well through 2022 to date. Perhaps unsurprisingly, at the top of the pile are inflation linked
bond funds which have benefited from higher inflation expectations and low real interest rates. Additionally, exposure to the US dollar via the CG Dollar fund of US Treasury Inflation Protected securities has been helpful. With limited exposure to the risk of rising interest rates, short dated corporate bond funds have proven fairly resilient while strategic bond funds have used their flexible mandates to limit the impact of falling bond prices. Notably, the managers of the Janus Henderson Strategic bond fund have used the weakness in government bonds to add to holdings. Like ourselves, they do not see yields rising much further as the energy shock, combined with the rising cost of living elsewhere, chokes back economic growth. Finally, our exposure to long dated, high-quality bonds, held as a hedge against economic weakness and deflation, having performed well over the last two years have been less helpful in 2022 as yields have moved higher once more.

 

Portfolio Positioning – Growth assets

As discussed above, the equity market rotation in the early part of 2022 saw investors move away from the strong performers of recent years, preferring instead the likely beneficiaries of maintained economic growth and higher interest rates. This left our core global funds trailing the indices over the year to date. On such occasions, rather than reposition to be on the right side of short-term movements, we always re-examine our core views and re- visit the fundamentals of the key positions in funds. On the outlook for markets, our view has been strengthened by recent events; economies will struggle to continue to grow through this interest rate tightening cycle, especially now it has been compounded by a commodity price shock. On key stock positions, we have been encouraged by the strong results reported by long term growth businesses – they are continuing to deliver, and we continue to prefer these companies. As Amazon’s announcement last week of a 20-1 stock split and an additional $10bn of share buybacks indicates, such companies have great resilience and should be able to deliver for shareholders, largely regardless of economic growth – or the direction of interest rates. What is more, valuations are beginning to look increasingly attractive after the rotation.

 

Outlook

In summary, we maintain conviction in our positioning. In the long term, companies with the ability to grow earnings are likely to deliver attractive returns, irrespective of bouts of volatility. In the near term, such companies provide a hedge against the scenario of deteriorating economic growth – whether this is driven by the interest rate cycle or a further deterioration in the situation in Eastern Europe. Considering equity markets more broadly, investors have already endured a meaningful correction to reflect the less supportive monetary policy outlook and the risk of a deterioration in the situation in Ukraine. While there is, of course, scope for further falls should circumstances worsen, markets are forward looking and have now discounted a significant amount of bad news. Finally, we should note that the ongoing volatility is likely to create opportunities for long term investors and, subject to our judgement about the prospects for markets beyond the current dislocation, we will be looking to adjust positioning to enhance long term returns.

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