31st May, 2023
May Investment Update
Looking at the year so far, our portfolios remain comfortably above benchmarks. At the same time, overall returns have been lower than we expected at this point given the prevailing market challenges.
In the first chart we are showing our Low to Medium and Medium Risk Portfolios against their respective peers, and in the second we are showing them against the major asset classes (equities, bonds and cash). The overall summary is that we are performing well compared to others, but that the main markets haven’t given us a huge amount of help as yet:
Taking a step back, our optimistic view on markets in 2023 was driven by the belief that inflation trends would moderate, interest rates would peak, and the fears of an imminent and deep recession would abate. So far things have played out largely as we expected, though markets haven’t quite enjoyed the benefits.
The significant gap we are still waiting to be filled is UK inflation, which despite a chunky fall from 10.1% to 8.7% in April, is still stubbornly high. When Rishi Sunak announced that his number one priority for 2023 was “to halve inflation”, he probably felt pretty good about his chances. It was 10.5% at the time, and there were nailed-on reductions in energy prices coming through. We have already had 4 months of data, and 8.7% is an improvement, but it’s been much slower than expected. That has implications for interest rate policy out of the Bank of England, who are now expected to increase the base rate 3 more times up to 5.25%… that’s a total of 15 interest rate increases in a row.
Against that backdrop it’s been a very difficult year so far for bonds. UK Government Bonds for example fell 4.5% in the month of May, leaving them down 4% in 2023. That’s after losing 24% in 2022 as well, which represented the worst year on record for bond markets.
As we’ve talked about a few times over the last 6 months, the upside of the volatility in bond markets, is that valuations have now got even more attractive. The income yield on our Very Low Risk Portfolio for example (which is 85% bonds), is now above 7% per annum. Low and Low to Medium have yields around 6%, and even High Risk will receive about 4% in income in the next 12 months. These are the highest yields we have seen since we launched the portfolios in 2008, and every month that goes by we will see more of an impact as it trickles in.
Looking forward, we find it hard to see how UK interest rates head above 5.25% (which is now expected), especially as we are likely at the peak in food price inflation, with large energy savings to come from July onwards when the Ofgem energy price cap is reviewed. In this respect they have already announced it will be reduced 17% below the level of the current government threshold, which will make a significant impact on people’s energy costs, especially as we head towards winter.
We therefore continue to expect inflation to continue to come down as we head towards the autumn. Although interest rates may go up a couple more times, this is now already priced in and we think further inflation falls will give policymakers the ability to pause. As long as we avoid a deep recession, which we see as highly likely, we are approaching a stage where all the pillars of strong returns are in place. It might be a few months later than we had hoped for, but good things are often worth waiting for.