DB Wood Team
8th April, 2022
Q1 2022 Investment Review
Much has changed since we wrote our 2022 outlook just three months ago. We have a war in Europe, an energy shock, and rising interest rates – quite the opposite of an ideal environment for markets. The silver lining is we enter Q2 with much more attractive valuations than we had at the start of the year, so despite the uncertainty, the platform for forward returns has improved.
We always felt there would be challenges to face as economies reopened, and the trajectory of inflation has illustrated that perfectly. Remember when the oil price briefly went negative in April 2020? Well even before Russia’s invasion, 20 months on, it was hovering just below $100 per barrel. Add in rising food prices and supply chain disruptions across a number of industries, and you end up with somewhere between 5% and 7% year on year inflation in most developed economies.
That has caused Central Banks to pivot from their long-term stance of accommodation. Here in the UK the Bank of England has raised interest rates three times across the last four months, and in the US the Federal Reserve have signalled similar intentions. Even before the invasion of Ukraine this had caused a significant correction in both bond and equity markets, with the conflict adding further fuel to the inflation fire.
Economically, that mix of higher inflation and falling confidence on the back of significantly higher geopolitical risk is likely to cause growth to slow. As prices increase quicker than wages, consumers are being squeezed, and are also less likely to spend given the political uncertainty. Parts of Europe are almost certain to go into recession over the coming months, with the UK having an outside chance of doing so too.
It really has been tricky out there, and therefore it isn’t a surprise that most equity markets were down between 5% and 20% at their worst points in Q1. The FTSE 100 actually finished the quarter in the positive (+2.88%), led by gains in energy, miners and financials, though all other equity indices finished in the negative. European equities naturally struggled and were down 8.36% on the quarter. Fixed income markets didn’t fare much better – the Vanguard US and UK Government Bond Indices for example, fell 5.54% and 8.17% respectively. About the only place positive returns were found was in commodities and property, but these are generally small components of a standard investment mix.
It was a brutal correction covering all corners of the investment landscape. However, it’s not all bad news – as we will argue in our outlook, the shift in expectations towards the negative scenarios has been so severe, that we now feel we have an excellent opportunity set on a 3-5 year view. As we often note, good returns always come from a lower base to start with – this correction could provide such a platform.
When investing its always important to retain a long-term perspective. In this respect, despite the correction, if we look back to March 31st 2019; a point in time well before Covid began; and fast forward to the same date in 2022, its pleasing to note that all our portfolios are ahead of their target annualised returns.
Whilst we expected a tough start to 2022, we didn’t anticipate markets to price in as many interest rate hikes as they had done by mid-February, so it hasn’t been easy in the short-term. Still, despite falls in valuation in the first quarter of between -2.86% (Very Low Risk) and -6.41% (High Risk) in Q1, we are still well positioned having hit our three year targets after enduring and recovering from hopefully the worst Covid could throw at us, not to mention now being in the midst of the first war in Europe since the 1940’s.
Although our portfolio range is only down modestly overall, the size of the correction in certain areas of the market has been considerable. Some of our holdings at their worst points had lost 20-30% without any real rationale. Take Barclays for example, which is held within a core UK fund we own called Artemis UK Select – it has dropped over 30% in the first quarter despite having no exposure to Russian debt and interest rates going up (generally supportive for banks). You therefore won’t be surprised to hear that in certain areas we have added to our holdings to take advantage of the price reductions.
At this point it’s important to distinguish between short term market adjustments and long-term trends. Adjustments happen when new risks come to investors’ attention, and market prices react to account for it. Generally, however, once they have been accounted for, long term trends tend to re-establish themselves, as the best business’ come to the fore and continue to deliver.
The Russian invasion began on 24th February, though prior to this, investors were already dealing with rising inflation and interest rate trends. Geopolitical uncertainty has reinforced the obvious need to own businesses with high standards, both sustainably and financially. That is very much where our core investment thesis sits, though despite those trends more suited to our investment mix, sometimes there is a need for drastic action, and as soon as we heard the news of Russian troops lining up on the Ukraine border, we exited our European equity positions and added to commodities. Our timing couldn’t have been much better, and since then we have taken profits on our commodity exposure and adding back into Europe at a 10% discount.
So, after a tough first six weeks, the portfolio journey improved as the quarter closed out. To illustrate since the date of the invasion they increased between 0.11% (Very Low Risk) and 4.31% (High Risk). A combination of positive portfolio activity and the invasion pushing investors to re-focus on quality businesses have been the catalysts, so we exit the quarter in a good position.
Markets represent an aggregation of people’s expectations, and generally people overreact both to positive and negative news. This quarter has encompassed a lot of negative news, and in our view, expectations have become overly pessimistic.
There is no doubt that inflation is a headwind for economies, and it is right that policymakers take steps to try to reduce it over time. In our review we talked about consumers being squeezed by higher inflation, and the additional effect on confidence from the Ukraine war. Even in our client base we are hearing of manufacturing business’ treading extremely cautiously given ‘price’ uncertainty. Inflation will no doubt cause a contraction in growth, though it’s what happens next which is the key question.
Economically things will likely slow as the year wears on, with recessions possible in Europe and the UK. Policymakers will face a choice of whether to continue to worry about inflation or start to worry about growth. If they choose the latter, as we expect, then it is unlikely that current expectations for interest rate increases will be met. In this environment we would expect that because our portfolio has a bias towards quality, that returns pick up nicely, despite the challenging economic background.
Even if the UK avoids recession, the chance the Bank of England raises interest rates another 6 times in 2022, is low in our view. The elephant in the room is how the situation in Ukraine develops – a protracted war will likely leave energy prices and inflation higher for longer, whereas a resolution will almost certainly cause commodity prices to fall. We have no edge in predicting what happens, though we hope that sense will prevail and prevent further humanitarian suffering.
So from here we have mapped forward a variety of scenarios. Our portfolios are therefore spread widely across asset classes and geographies, though we are overweight in the US where we think growth prospects look strongest, and the overall theme of “quality” remains. We feel on balance markets are too pessimistic on interest rates and inflation, and an improvement in any one of those variables could see a positive market surprise.
At the same time, we have added some protection to the portfolios, especially at the lower risk end through Government Bonds and high-quality credit. For the first time in years, we can access solid income streams of 3-4% without taking significant risk. For low-risk clients the bond correction has been a gamechanger, and so from here we are much more optimistic that we can at long last get a healthy return contribution from this asset class.
The next few months are going to remain challenging, though where there are challenges there will be opportunities. Despite a difficult Q1, it is important to remain pragmatic and patient. In our view, outside of further expansion of Russian aggression beyond Ukraine, most of the market adjustment has already happened, and we have portfolio’s holding excellent business’ that irrespective of interest rates or geopolitics, should keep delivering profits. The timing around the journey is again uncertain, a little like the Covid vaccine, however we are optimistic that 2022 will progress in a more positive way than it has started, though rest assured we are prepared for all potential outcomes.