Market Review

The market environment of 2022 was vastly different from the decade that came before it. Low inflation became high inflation, supportive policy moved to be restrictive, and with that, investment markets went through a huge period of adjustment.

Policymakers have always feared higher inflation because it can become self-fulfilling. People see prices go up, and as we are seeing now with a multitude of strikes in the UK, have no choice but to demand more pay, which in turn fuels prices to rise again. Their only choice at that point is to raise interest rates and cause a recession, which cools the jobs market and inflation in tandem.

The UK, Europe and US have all been through the first part of that journey, and in Q4 signs of the second stage started to come to the fore. For one we saw improvements in inflation data, with the US seeing price rises of just 1% over the last 5 months, and the UK slightly worse off but still past the inflation peak seen in November. Economic data started to deteriorate too, with house prices nudging down, and manufacturing and retail data slowing.

The big takeaway here is that in Q4 investors moved from worrying about the cause, to worrying about the effects. Inflation will fall back, and interest rates will peak, but what has all that change done to the economic outlook? That is now that key question.

With respect to markets specifically, Q4 was generally positive for stock markets. UK and European equity markets were strong performers. Outside of that things were tougher though, and the US finished the quarter in negative territory. A typical basket of global equities was up around 1.86% over the period (MSCI World).

In our last blog we talked a lot about the opportunity in bonds, which not that far back in September were in free-fall on the back of the Truss policy announcements. Pleasingly the asset class also had a good quarter, with the DB Wood bond bucket as an example, adding 2.6% in those three months.

However, although Q4 was better, it is worth remembering that 2022 as a whole was one of the toughest environments we have ever seen. In fact, since records began, a standard 40/60 portfolio (40% equities, 60% bonds) has never had a worse outcome. The UK 100 index was the standout performer, finishing the year up 4.7%, but markets like the tech heavy Nasdaq index lost 25% of its value, as did UK Government Bonds in stark contrast to their usual performance in difficult markets.

Overall, Q4 was a solid quarter for returns, but still left 2022 as one of the worst years for investment performance ever. Part of the improvement was due to the intense negativity already in prices as we entered Q4, and part of that a release of pressure as inflation showed early signs of improving. We think it reflects that the big adjustments have now happened, and although we now have to contend with the effects of the policy changes next, the return environment is now much more favourable.

Portfolio Review

Q4 was a good quarter for the portfolios, with them adding between 2.87% (Very Low Risk) and 4% (High Risk) depending on the risk profile.

We’ve talked a lot about being active in our decision making, and that’s particularly important when the landscape changes, just as it did in 2022. Moving forward we are almost certainly in a different investment world than we have been for the last 10 or so years, and that will bring with it different risks and opportunities.

A large part of the last year was about repositioning the portfolios for this new environment. Some of our equity holdings which had performed extremely well through 2020 for example, aren’t as suited to a higher interest rate world. Moreover, in a difficult economic environment the good and bad companies generally get exposed, leading us to have a higher preference for ‘quality’ businesses over those with potentially higher but less predictable growth prospects.

The re-emergence of income, specifically in bonds, is another game-changer for future returns. We can now access high-quality bonds yielding between 5-8%pa whereas a year ago 2-3% was hard to come by.

The upshot of all of that is that our portfolios look significantly different in their composition than they did 12 months ago. They are more cautious and high quality in their equity exposures, and we’ve increased our bond exposure markedly. In Low Risk for example, bonds now represent more than half the investment allocations, compared to around a third a year ago.

We all-but removed our commercial property exposure in early Q4, concerned that the adjustment in the property market had not yet been felt, with other asset classes offered much better value.

When combined, we now have a higher-quality, more income-driven set of investment opportunities. Specifically on the income point, the lower risk portfolios continue to yield more than 5%, and higher risk close to 4%. Both give us a great underpin to returns moving forwards. As such we have revised our return forecasts higher for the next 3 to 5 years.

The overall numbers for 2022 were poor, though Q4 showed improvement. We believe that’s more reflective of where we are going than where we’ve come from, and that the portfolios are positioned strongly both for now, and when investment markets pick up. We might have to wait a little bit for the latter, but it doesn’t feel too far away.

Market Outlook

Our three-year investment view is a very positive one. We start that period with good valuations across the main asset classes and a high level of income being generated. Markets are now looking for direction dependent on the effects of inflation this year, rather than worrying about the cause itself. The cause (inflation), will likely reduce quickly as we progress through 2023.

As we are further through the journey, we have had much of the pain. Specifically, there is now more opportunity for things to get better. Markets are still concerned that inflation stays higher for longer, that Central Banks will raise interest rates too far, and that a recession will be deep and long. If any or all of those things turn out to be not as bad as expected, then the relief will help markets to perform well.

The greater economic risks sit in the UK and Europe, where inflation is likely to stay persistently higher and economies are slightly more fragile. At the same time, although the news flow on Ukraine has reduced, its importance to the investment world remains high. Any sniff of peace talks would cause European assets to rally, and so although it is an area of risk it is also one of opportunity.

Our base case is that inflation falls progressively through 2023, interest rates peak within the next 3-4 months, and developed economies experience a mild but not catastrophic recession. However, as always there are a variety of scenarios, and we need to see the inflation data and subsequent Central Bank decisions to validate our view. In this respect it could be 3-4 months before markets really get direction again.

Importantly, although things remain uncertain, its worth remembering that our starting point is significantly better than it was just a year ago. We sometimes feel like we are banging on, but a 5% income yield means that if share prices and bond prices finish the year exactly where they are today, your portfolio should return 5%. This is the game changer. It allows far better protection against capital falls, and a great starting point if our base case does turn out to be right. Typical capital growth averages should be 3% pa from low risk current levels, so when added to our income yield of 5%, the total return potential looks very attractive. Capital values themselves look very attractive in certain geographies, so this means the potential for forward returns is now significantly better than at any point in the last 10 years.

Overall, we remain cautious in the short-term and positive in the medium to long. The portfolios have both an income and a quality focus and have also retained a moderate cash weighting that provides us with opportunity to add to ideas if we get further volatility. The next 3-4 months are going to be important to determining the market direction, but its one that on balance we expect to develop positively the further we get into 2023.