Background and market drivers past 12 months and last quarter
We think we might now be getting nearer to the end of the period of adjustment in asset prices occasioned by the sharp rise in interest rates that began in late 2021. It has taken nearly two years but, for investors, has felt like an eternity since we last had much to be optimistic about.
What we have seen in markets has been painful for almost all asset classes but is to be expected when the cost of money increases sharply. The challenge for 2023 has been the lack of safe havens with most equities, bonds, alternatives and cash all delivering negative real returns, something that should, in theory, provide opportunities ahead.
Having seen a rally earlier in the year, particularly in US Large Cap tech stocks and mainly based on enthusiasm about the possibilities of Artificial Intelligence, persistent policy uncertainty has meant that some of those gains have been given back throughout the summer months. This is perhaps healthy as valuations looked quite high for a number of those companies, but it has not helped investors.
Inflation and Interest Rates
Investment sentiment continues to be driven by Central Bank interest rate decisions and rhetoric. The level of scrutiny has increased with market participants not only reacting to rate announcements but scouring the nuance of every comment issued by individual central bank officials, trying to guess the next move. Central Bankers rely on mainly lagging indicators and rate rises take time to have an effect – for example with many people on fixed rate mortgages it often takes 12-24 months for higher rates to bite and affect consumer behavior, but we are probably nearing that point now.
The likelihood is that rates are nearly at their peak; they may plateau for a while, but the expectation is that they will then start to come down. This is an example of where bad news in the real economy can be good news for markets and investors.
History tells us that inflation can be quite persistent, and we continue to think it likely that inflation and interest rates will come down to the 3%-5% range but might stay there for a while. We are not expecting rates to fall to pre-pandemic levels anytime soon (all else being equal!).
Quality, Value and Growth
After 10 years of domination in an era of near zero cost of capital, we think that the ‘growth’ style of investing is likely to be a less consistent way of generating returns. The significant re-rating in some parts of the market means that many previously overvalued companies are now attractively priced, and shares should react well to a reduction in rates. That said, we no longer think a large weighting is sensible given the capital hungry structure of many of the businesses in the ‘high growth’ sector, which may lead to less predictable returns over time.
Conversely, many of the unloved but perfectly healthy parts of the market that would traditionally be classed as ‘value’ (such as Financials) as well as high ‘quality’ companies with solid cash flows and low levels of debt are likely to perform more consistently given the lower starting valuations and reduced sensitivity to changes in the cost of capital. These companies are inevitably less exciting to watch and commentate on than Tesla and the like, but we think that companies with more reliable earnings, customer bases and pricing strategies will be the bedrock of portfolio returns whilst rates remain at these (more historically normal) levels.
Fixed Interest
As mentioned in other recent updates we have started to become interested in Fixed Interest/Bonds as a sector after many years of avoiding it. Having previously provided little diversification benefit from equities and lower return prospects, Bonds are now starting to pay more respectable levels of income and given the significant change in economic fundamentals, they should finally be able to offer the sort of downside protection in a recession that investors have been more used to in the past.
It is easy to forget that the Bond market is significantly larger and more complex than the equity market and, over the past year or so, the sector has experienced widespread (and in some parts of the sector perhaps unjustified) selling. This means that experts in the sector should be able to benefit from this widespread re-rating, picking up bargains and patiently collecting the income until the market corrects itself. For this reason, our preference is to use ‘Strategic Bond’ funds where the manager is able to be nimble and invest in areas where they see the best value, as bond markets tend to move fast in response to interest rate changes.
Small and Mid-Cap Companies
As with almost all bear markets, the smallest companies usually suffer the most. Businesses in their infancy, often reliant on debt, are inevitably impacted by stock markets falling, capital raises drying up and the cost of debt increasing. Small and Mid-Cap equities, in general, exhibit higher levels of volatility which has historically meant underperformance in falling markets but outperformance in rising markets.
It is during these periods of market uncertainty that it feels most uncomfortable to own Small and Mid-Cap companies, but with valuations down significantly from their 2021 peaks, this could be a good opportunity for those willing to accept short term volatility in part of their portfolio in pursuit of long-term gains.
As with the Bond market, the small and mid-cap market is wide-ranging and complex. There are many great opportunities, but many companies will also fail. The sector is significantly under-researched so specialist, actively managed funds able to dedicate their time researching these companies and meeting management teams should, we think, generate good returns relative to benchmarks over the long term.
Alternatives and Real Assets
This sector is made up of many things, but our portfolios primarily feature infrastructure, renewables, commodities and specialist real estate (e.g. Distribution Hubs and Healthcare Facilities). For many of the same reasons as Fixed Interest, much of the sector has struggled over the past 12-18 months. Following this poor year for returns, we are now able to access high quality Real Assets through several specialist Investment Trusts at discounts of over 10%, while generating yields of 6%-8% pa (albeit not guaranteed). We see this as a good entry point and a useful source of income should volatility persist.
Commodities have been volatile but have provided, at times, useful diversification from equities. The terrible conflicts in both Ukraine and the Middle East will inevitably affect oil producers – we have already seen price increases here. While we do not think this is the most likely outcome, the potential for stagflation (low levels of growth, high unemployment and stubbornly high inflation) could also be supportive for real assets in general, such as infrastructure and many parts of the commodity markets.
Asia and Emerging Markets
Asia and Emerging Market economies are often hard to predict over the short term but are proving an interesting source of diversification from Western economies – with much of Asia seeing stubbornly low levels of inflation and more growth focused Monetary and Fiscal policy. Their relatively young demographic and growing middle class should also be attractive for long-term returns.
Emerging Markets are far less reliant on the US Dollar than they used to be, however, this still plays an important role in their economies and, should we see some risk appetite return, we would expect USD to fall in value, which would provide a tailwind for Emerging Market equities (to what extent is hard to say).
We remain cautious of direct investment in China due to continued signs of poor corporate governance and heightened political risks – both difficult to accurately price into markets. For this reason, we favour India and the economies that surround China over direct exposure to Chinese equities. Through holding specialist, actively managed Asia funds with managers whose views on the region are generally aligned to ours, we aim to mitigate much of this risk whilst allowing the manager to navigate the everchanging Asian economic and political landscape and gain exposure to economies that should provide long term growth.
Within Asia, we are increasingly positive on the prospects for Japanese equities given structural reforms that are being introduced to Japan’s stock market. These reforms are designed to encourage constituent companies to reinvest cash either through R&D, acquisitions or share buy-backs in order to remain part of the main indices. This should be positive for more persistent growth in the sector – of which we are starting to see the early signs.
The Fallacy of Market Timing
We are always reluctant to focus too much on the past. Indeed, from an investment perspective, it is important to remain focused on the future – with the investment winners and losers of the previous 12 months rarely looking the same 12 months down the line. That said, it would be foolish to ignore the lessons of past market cycles that look and feel like the current environment.
One such lesson to consider for investors now is the apparent attractiveness of Cash– you might be able to get upwards of 5.5% on a 12-month fixed deposit – relative to investments such as Equities and Bonds where returns over the last 12-18 months have been poor and volatility levels high. While it is always difficult (and often foolish) to consider timings with too much weight, if one looks back over previous bear markets it is usually the sectors that have been the most painful to own, which provide the basis of the recovery once uncertainty fades and more normal markets start to return.
Again, this time could be different, but historically market recoveries occur sporadically over a relatively small number of trading days rather than evenly from the bottom of the market – sometimes for obvious reasons such as better than expected data readings or market friendly policy decisions, and often for reasons that are far less clear, but usually before most investors are able to react and re-position. Should markets begin to recover over the next 12 months (something we are hopeful will be the case) and should this look similar to recoveries from bear markets of the past, then it is likely that those no longer participating in the market (i.e. holding cash) will struggle to re-invest at the lowest valuations and will miss several of the most important days for the recovery. By simply holding firm in a portfolio constructed with the future in mind, history tells us that outperformance is far more likely.
Green shoots of optimism
Whilst this trajectory of interest rates should be more positive for markets over the coming 12 months than they were at the beginning of the rate hiking cycle, the short-term experience for investors is likely to be much the same; short-term market speculators creating heightened volatility as they attempt to cash in on changes on interest rate decisions (something that is extremely difficult to execute profitably without a great deal of luck and risk of permanent loss of capital).
This heightened volatility is experienced by all investors but is only truly costly for those making short-term decisions. For long term investors – such as Thomson Tyndall – it should be a sign of better times ahead, with the main speculative bets focused on timing the normalisation of markets (and interest rate policy) rather than their deterioration as had previously been the case. With this in mind, maintaining a well-balanced and diversified portfolio (and one’s nerve!) rather than making short term speculative decisions should result in good long term real returns. With this approach, the volatility we are seeing at the moment, whilst uncomfortable, should only represent a short-term irritation rather than a long-term cost.
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.