After a difficult 2022, with pessimism still abundant at the start of the year, most markets got off to a surprisingly good start in Q1. January and February saw positive returns from most markets and asset classes. March proved rather different with the failure of Silicon Valley Bank in the US and anxiety about the risks of a GFC style banking crisis haunting investor sentiment. Whilst it seems to us that the reasons for the collapse of SVB, and now other banks including Credit Suisse, were very different from the crisis of 2008/09, these worries highlighted how fragile the rebound was and how rapidly optimism can turn to pessimism. Even with March’s worries, developed markets performed well – Europe (+9.6%) the US (+4.4%) and the UK (+3.6) – during the first quarter*.
With inflation persisting and most central banks having raised interest rates very rapidly over the past 18 months, fractures in the system are to be expected: higher interest rates put companies, banks and consumer spending under pressure and, although markets fell in 2022, the speed of these rate rises has probably not allowed sufficient time for readjustment from the decade or more of cheap debt that we had all become so used to. Most investors had largely forgotten that interest rates of 4-5% are in fact more ‘normal’ in historic terms.
So far, corporate profits (which ultimately drive long-term stock market returns) have mainly held up well. But the twin effects of inflation and the cost of debt mean margins are now declining for many companies, and we are expecting weaker profits in 2023. Emerging markets could buck the trend as China reopens post-Covid, but we do not rule out the possibility of recession in many developed countries including the UK. If history is ever a guide, our collective faith in Governments and central banks to manage interest rates to achieve a smooth pathway to sustainable growth without a recession may be misplaced.
Our central thesis is that although inflation is showing signs of coming down (mainly for technical reasons due to higher input/energy costs 12 months ago) it is likely to be more persistent than first thought. We think that most major economies are likely to see higher inflation and interest rates for some time (particularly the UK where Brexit-induced staff shortages and supply chain frictions persist). Our expectation is that interest rates are unlikely to fall back to 2021 levels any time soon unless there is another, as yet unknown crisis. We expect rates to settle in the 3-5% range for some time. If we are correct, the winners are likely to be different types of companies than those that did so well in the era of cheap money and lockdown spending. Companies with high debt and stressed balance sheets and/or those that have yet to achieve profitability are likely to struggle with more traditional, albeit slightly less exciting, companies with reliable cash flows likely to outperform.
As we have mentioned in previous commentaries, there is generally a lag between markets and the real economy with markets tending to be forward looking. So, whilst there are undoubtedly headwinds in the real economy, there are still reasons for optimism and opportunities for investors to generate good returns. Doing so will require a more diligent and selective approach than the ‘rising tide which floats all boats’ momentum/index tracking strategy which had worked well prior to 2022.
UK & European Equities – Quality and Value Opportunities
Investors with longer memories will be familiar with the expression ‘Blue Chip’ – an early twentieth century Wall Street term, borrowed from the world of poker (blue chips were the highest denomination tokens) – used to denote the high quality, usually dividend-producing stocks of reputable companies. We have always liked dividend payers and include Equity Income funds as a core holding in most client portfolios.
For those seeking income, dividends are obviously helpful but, if not needed, the compounding power of reinvesting the dividend has been a very good long-term source of growth too. Even when such companies are considered boring and out of favour (as has been the case for most of the last decade) we think of dividends as a way of being ‘paid to wait’ until the market takes a more favourable view. For historic and structural reasons there are more of these companies in the UK and Europe and as both markets have been out of favour for a number of years, this should offer a good entry point on a long-term basis. Within our equity allocations we are generally adding to these markets.
US Equities
For some time, the performance of the main US indices has been driven by a handful of very large Tech companies. Whilst many of these are perfectly good businesses, high prices have made them difficult to invest in on anything other than the most optimistic scenarios for future earnings growth and recent developments in AI have shown that even the disruptors can be disrupted – a fact that should have been self-evident! There are still many good quality and reasonable businesses in the US and huge government infrastructure spending provides a tailwind in some sectors. We still like the US but are more cautious, preferring experienced stock-picking managers to index trackers at present.
Asia and Emerging Market Equities
As China re-opens and its population starts spending again, the prospects for Asian and Emerging markets are looking good; these markets have had a muted start to the year but should do well over the long term, benefiting from healthy demographics and, over the shorter term, from a weaker US Dollar. We remain wary of direct exposure to China for geo-political reasons, but there are several Asian funds that give good exposure to the region whilst mitigating that risk to some extent.
Alternatives – Infrastructure, Property and Renewable Energy
These investments have had a tough 6 months but generally produce a high income and, as many are investment trusts, currently trade on deep discounts to the underlying value of their assets. In most cases we think these have been over-sold and represent attractive alternative sources of income and good diversification on a long view.
Bonds – Fixed Interest
Having been very negative on this sector for some time, recent rate rises and the resulting correction in values last year have now made this sector more attractive. Bond yields are now at more healthy levels, and we would expect capital growth if/when interest rates start to come down again. Having been underweight bonds we have started cautiously and selectively increasing exposure to bonds in client portfolios as they now look like a useful diversifier again.
Summary
Our focus in the current environment is careful investment selection. We think this market is likely to favour experienced and high-quality stock picking fund managers who fully understand the companies in their portfolios and who have weighed the risk that higher interest rates pose. If we do see an earnings recession, it is likely that poor companies will fail, but the corollary is that the higher quality survivors will benefit from reduced competition and better financial discipline – both of which are good for long term returns.
As the adage has it ‘Bull markets climb a wall of worry’ and it is usually only with hindsight that one can spot the starting point, but overall and in spite of the gloom, there are good opportunities to be had in many sectors at present. In the short term there will be the usual noise and fury but, as always, a long term well diversified approach will see us through.
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.
*Source FE Analytics, Q1 Performance of the MSCI Europe ex UK, S&P500 and FTSE 100 – 01.01.23-31.03.23