Happy New Year!
After three successive years where the performance of stock markets has been disconnected from the state of the real economy and with gloomy predictions of impending recessions this year, we are hopeful that markets will again buck the trend. Markets are thought to price in all available information and anticipate the state of the real economy about 12-18 months ahead. With this in mind, as we start 2023, we expect markets to be already looking through recession and starting to price in a potential recovery in late 2023 or early 2024.
The major influence on stock market direction this year is likely to be the path of inflation and central bank interest rate rises. We are sure you will not need reminding that the cost of living spiked sharply upwards in 2022 and central banks, led by the Federal Reserve in the US, have raised interest rates aggressively to combat this inflation. This has had the effect of increasing the cost of debt (both personal and corporate), encouraging saving behaviour over investing and in general making less money available in the real economy. If one looks at the longer span of history, what we have seen is simply a return to more normal interest rates after a period of unusually cheap and readily available credit that has existed since the Financial Crisis of 2008/9. However, as the wider market had got so used to very low rates, 2022 proved a very painful year as most investors have had to reluctantly capitulate and change their approach. Most projections show interest rates stabilising between 3.5-4.5% so what worked in the past decade is less likely to work in the future.
In 2020/21 ultra-low interest rates and lock-down stimulus measures favoured growth stocks and speculative assets, fueling bubbles in many asset classes. This irrational exuberance was perhaps most evident in the Cryptocurrency arena with the meteoric rise of Bitcoin etc – instruments which offer no tangible return except the hope that someone will be prepared to pay more for them in future. 2022 proved to be a year in which, if the music did not entirely stop, it certainly slowed dramatically. Perhaps mercifully, so far, Crypto has not been sufficiently integrated into mainstream financial systems to affect traditional investments any great extent, however a similar picture – greed giving way to fear – could also be seen in the performance of many of the ‘disruptive’ growth stocks – many falling dramatically over the course of 2022 e.g. Zoom (-63%), Tesla (-65%), and Netflix (-51%). *
Inflation, the war in Ukraine and growing geopolitical fears caused investors to rotate from growth to quality/value stocks, with energy, financials and defence stocks performing best in 2022. These are disproportionately represented in the FTSE100 index which was one of very few markets to end the year in positive territory, +1.5%. For reference, the S&P 500 was down -19% and Nasdaq -32%. With most developed markets down between -10% and -20%.*
What to expect in 2023…
Our central expectation is that we will see inflation figures start to fall. Inflation is a year-on-year measure, so as factors such as the very high oil price ($119/barrel in March 2022 vs $80/barrel now) start to become the reference point, the headline inflation numbers should naturally reduce. The effect of several rapid interest rate rises should also start to slow consumer and corporate spending, decreasing demand. The trend should be downwards in the first half of 2023. To be clear, prices will still be rising, but the rate of increase should be slower. In turn we would expect most central banks to ease or pause the path of rate increases over the course of this year as growth/recession becomes a greater risk than inflation. The risk (unpopular as this might sound) is that wage inflation becomes ingrained and that at or above inflation pay rises are given to the many (often deserving) workers currently clamouring for them – if this comes to pass then inflation and rates may remain higher for longer.
Geopolitical Issues
Sadly, we expect the war in Ukraine to grind on and energy prices to remain at elevated levels. The key political risk is that western democracies lose patience with the pain of higher prices and press for peace with Russia – an emboldened Russia and by extension China’s view on pursuing its claims on Taiwan would be bad news in the longer run. We are also mindful of the challenges of China’s recent change to its zero Covid policy and the potential for further waves or new variants to emerge.
Western governments and companies, now more aware of issues such as energy security and technological dominance, are shortening supply chains and bringing key industries such as silicon chip manufacture onshore. This de-globalization, whilst possibly inflationary, is potentially good for domestic economies in the developed world, but in the long term a decrease in trust and economic integration is not good for global growth.
Where to invest if this is the ‘new normal’?
The good news for long-term investors is that on most historic measures stock and bond markets, whilst not cheap, now look better value. Much of the hype and exuberance has been shaken out of markets over a very tough year, particularly for those newer to investment. Most of the headlines are glum – recession is likely, corporate earnings are expected to fall, everyone is feeling the squeeze in living costs. Counterintuitively, this much fear and bad news combined with lower valuations tend to herald a more positive outlook for future returns. In such circumstances the rational pursuit of good quality investments generating real returns and offering investors the prospect of keeping pace with inflation is a sensible approach.
Thomson Tyndall Current Thinking
The following is a simplified summary of our current thinking – it should not be treated as a recommendation to buy or sell any specific sector or investment and is, as always, subject to change.
Cash – Now paying more than it has in a while but still significantly below the rate of inflation. It is sensible for liquidity and as an emergency fund but is still not a good investment.
Bonds – Corporate and Government Debt –These have been overvalued and unattractive for some time and we have been significantly under-weight in client portfolios, however a sharp fall in value in 2022 is now making income yields in some areas of the bond market more attractive – we plan to start cautiously adding to this sector.
Property – Uncertainty over the return to office work, and fears of recession on the high street make traditional property investment unattractive, however we are finding attractive opportunities in the specialist property sector, funds that invest in warehouses, data centers, and care homes with long leases and quality tenants should provide a good source of diversification and income.
UK Equities – For a number of reasons including Brexit, the UK market is cheap relative to other developed markets. The FTSE100 performed relatively well in 2022 but UK small and mid-cap companies have been hit hard. Looking through recession and seeking careful and selective stock-picking fund managers in this space should deliver good returns on a medium to long view.
Developed Market Equities – For the US, low levels of unemployment and the capacity to recover quickly continue to make it an attractive area for investment, albeit from higher valuations than the UK and Europe. Europe (whilst fraught with political issues including the war in Ukraine) is looking cheap but has a number of excellent global companies listed on its stock exchanges – so for different reasons both offer some good opportunities for investors.
Emerging Markets – Much depends on US$ strength – a weakening dollar is generally good for Emerging markets although for reasons outlined above, we remain cautious of China and have tried to avoid Russia altogether. Opportunities certainly exist in Asia and Latin America for investors prepared to take a bit more risk.
Absolute Return – Defensive ‘Absolute Return’ funds have generally performed quite well in 2022. We intend to gradually take profits from these as the economic picture improves and deploy cash in areas more likely to benefit from recovery.
Alternatives – This is a sector we have liked for some time and includes investment in areas such as Infrastructure and Renewable Energy. Many of the funds in this space offer long-term inflation linked income streams and pay good dividends. For technical reasons the sector suffered in the second half of the year, but many funds are now trading at a discount to their Net Asset Values, and we think offer an attractive risk return profile, particularly for income investors.
As always, our approach is to maintain broad diversification by sector, style, and geography across client portfolios. If the last few years have taught us anything it is that we can never be certain what new shocks might emerge, but we think that investing in high quality, profitable companies with the capacity to defend against inflation via well managed funds that can be nimble and reactive to change remains a sensible approach.
This note is intended as a general market update and should not be regarded as specific advice or treated as a recommendation to invest in any particular fund or asset class. Stock market investments can fall as well as rise. If you would like to discuss the implications for your own portfolio, please do get in touch.
*Data Source: Trading Economics 03.01.23