Commentary on October 2022

Market Overview

It’s been another tumultuous month in the UK. Politics can be a cruel game. As the month wore on, it became increasingly clear that a series of policy U-turns following the fallout from the mini-budget wouldn’t be enough to save the credibility of the new leadership. One by one a fatal blow was dealt, first to the new chancellor Kwasi Kwarteng, followed by the Prime Minister Liz Truss herself, amid chaos in the markets that saw gilt yields spike above 5% at one point. The Bank of England was able to steady the ship, intervening to prevent a potential collapse in defined benefit pension plans. Calm was then finally restored with the installation of Rishi Sunak as the latest occupant of number 10, in a selection process that lasted a mere four days! Under his leadership the UK will likely see a much more fiscally conservative government. This brought immediate relief to bonds, stocks and sterling that at the time of writing are all trading back at levels prior to the crisis.

While calm was restored in the UK, volatility picked up elsewhere. In China, equities sold off sharply, as President Xi Jinping was confirmed for a third term and was able to greatly consolidate his political power within the party. Investors were dismayed as he defended China’s zero Covid policy, stating that it would remain in place for the foreseeable future. The economy has paid a heavy price for continued lockdowns, contracting in the second quarter by almost 3%.

The earnings season in the US has been mixed. Netflix and Bank of America announced strong numbers, along with leading companies in healthcare, defence and energy. However these were offset by disappointing numbers from a range of other big tech bellwethers including Alphabet, Microsoft, Facebook parent Meta and Amazon, sending this sector sharply lower. The impact of the economic slowdown is increasingly evident, with a deceleration in the overall growth rate of earnings to around 1-2%.

The macro economic environment has remained challenging, with headwinds from both high inflation and slowing growth, the latter being squeezed by a combination of higher interest rates and the rising cost of living. The US has remained the most resilient among major Western economies, but even here multiple leading indicators are suggesting that the cycle is turning down. Lagging indicators such as jobs and inflation should soon start to follow.

While the US Fed has maintained its hawkish rhetoric on interest rates, cracks in the narrative are beginning to appear elsewhere. The Bank of England deputy governor indicated that market expectations for the future direction of interest rates are currently too high, particularly given the outlook for greater fiscal constraint under Prime Minister Sunak. Authorities in New Zealand, Canada and Europe echoed this message, all signalling that they expect the future pace of rate hikes to slow, causing a rally in bonds worldwide. Equities also closed higher across major Western markets, recording gains of between 3% and 4%. However Asia and emerging markets closed lower, led by a fall of 18% in Chinese stocks.

Our Views

Calm has now been restored in the UK after several weeks of turmoil. This is a timely reminder that, while it’s easy as investors to get caught up in short-term news flow, political affairs are not generally a driver of long-term returns. Recent events do demonstrate, however, that there’s limited scope for policy change – any supply-side revolution will have to wait until the economy and its fiscal position are on a more solid footing. This applies to most Western nations whose fiscal positions have deteriorated following the cost of the pandemic.

Tech stocks have been in an unrelenting downtrend since peaking in February 2021, following an unprecedented boom in demand for their services during the pandemic that drove share prices to extreme highs. Share prices have since been savaged, as it become clear in hindsight that valuations should not have been priced as if these exceptional conditions would continue forever. This is the key reason we have sought to minimise exposure to this sector in recent years. News flow was extremely positive at the time but valuations were approaching bubble levels, suggesting that risks were rising. When the cycle turned down, only the most nimble of investors made the exit in time. A large portion of the valuation premium in this sector has now been erased by falls over the past year but it may take some time for investors to return.

The best long-term driver of returns is the price you pay. Buying assets cheaply while they are out of favour and holding over the medium term is generally a good way to generate low risk returns. It does however require patience. Investing in the UK has tested the patience of even the most stoic. Equities have been cheap and trading at a considerable discount to other developed markets for some time. A series of setbacks such as Brexit uncertainty and the pandemic have been followed by the return of inflation, rising rates, the prospect of a recession and a series of political crisis. Hence the value has not yet been realised. Throughout this period however, UK companies have generally churned out a great dividend yield (with a brief hiatus Covid). Dividends are currently accruing at a rate of 4.2% per annum while we wait for the clouds to clear. In this case, compared to more glamorous areas such as US tech, slow and steady wins the race.

How are we currently positioned?

From an investment perspective these are challenging times. Corrections are an unwelcome but normal event over time, as markets often get ahead of themselves and need to reset periodically. The decline this year has felt worse following on from years of relatively smooth returns generated during the exceptional environment of QE and low rates.

Diversification is key to riding out these storms and our standard portfolios have proven much more robust than their respective benchmarks. Current risks remain finely balanced between high inflation and weaker growth. Our portfolios remain structured to reflect either outcome (or both). Overall equity exposure is focussed on defensive areas such income funds that own companies with strong cash flow and resilient balance sheets. These should provide relative safety as the growth outlook slows. We are happy to keep risk low and accumulate dividends during this period of uncertainty. Our portfolios also own assets that should prove relatively robust in and even benefit from a higher inflation environment, such as index-linked bonds, infrastructure and renewables, along with real assets such as gold bullion and precious metal and commodity stocks.

The UK economy, along with Europe, is forecast to remain in recession throughout 2023. This isn’t surprising news – much of the bad news is already reflected in prices as markets have now had almost a year to adjust.  A bear market is however unlikely to last this long, as markets tend to bottom and recover ahead of economic data. An attractive entry point is anticipated in the not too distant future.