Q1 2023 Market Review

2022 will go down as the worst year for equity and bond markets in 45 years. There have been periods where in isolation, equities or bonds have performed worse, but never at the same time. The re-pricing of all assets for a higher inflation and interest rate backdrop really was a challenge, and with 2022 now in the rear-view mirror, this year investors were hoping for a more favourable environment.

The first quarter saw some progress in that respect, with inflation starting its downward trajectory across the major developed economies and Central Banks slowing interest rate increases.

It would be fair to say it’s been bumpy, with the UK for example seeing a -0.6% inflation rate in January and 1.1% in February. The annual rate is still at 10.4%, much higher than we want, but it is down from 11.1% in October. The first two months of this year, point to inflation falling to around 3% by the end of this year, though we expect the run rate to slow beyond this.

Comparatively, over in the US progress has been more consistent, with inflation falling from the 9.1% peak in June last year to 6% at the end of February. Importantly, we are past the 1-year anniversary of the war in Ukraine, so there is an expectation that the pace of monthly inflation falls will increase from here.

Central Banks like the Bank of England have hiked interest rates from 0.5% this time last year to 4.25% to curb inflation, so with the results now trending in the right direction, they have started to release guidance saying they are closing on their peak.

Up until early March, everything was looking rosy. Inflation and interest rate uncertainty was reducing, and economically all major economies continued to show resilience, and previously forecasted recessions looking ever less likely. Equity markets were starting to reflect that positivity, for example the FTSE 100 and MSCI World up around 7% to 8^th March. Bond investors also saw reasonable gains across January and February, in what was, until that point, a broad market recovery.

The banking issues in US and Switzerland quickly changed that picture, however. First, we saw several US banks face liquidity problems as customers receiving close to zero return on their cash moved money into higher interest-bearing accounts with alternative banks. This was closely followed by Credit Suisse (who have been in turmoil for quite some time) who announced they were on the verge of bankruptcy. Suddenly investors had to worry about banking risks, bringing back memories of the global financial crisis in 2007 and 2008.

Our opinion is the banking situation is nothing like 2008. We will expand on this further in our investment outlook. In the meantime, it’s important to note that the majority of market gains for the quarter were eroded over the last few weeks. The FTSE 100 index, which is heavily populated by banking stocks, lost around 9% of its value, falling from its all-time high on February 16^th.

Positively, as we close out on the quarter, the market is normalising, suggesting that our central case remains intact.

Overall, it’ s been good to see the key risks trend in the right direction, and despite the banking worries being added into the equation, Q1 was a slight positive overall. Our view is that the results don’t really reflect the reality which is there has been a significant amount of progress in the things that really matter.

Portfolio Review

Our primary focus across the last year has been to take advantage of the new opportunities markets had created. It’s worth emphasising the word “new”, because we have not seen the same types of opportunities since we launched our model portfolio range in 2008.

Investment markets are profoundly different in 2023 compared to the last decade, with the key change being the ability to drive a high level of ‘income’ as a source of return. Just in the same way previous cash rates were 0% and are now 3%-4%, bond incomes returns have moved from 1 to 5%, to 4% to 12% depending on the market and type purchased.

We rotated our portfolios significantly over the last 12 months, with 2022 representing our most active year ever. We are now overweight to fixed income (or bonds) and the income yields on the portfolios are between 4% (higher risk end) and 6% (lower risk end).

The income story has been reassuring to a lot of clients, though we have also had a lot of well-placed questions asking, “how do I see it?” The challenge here is that income is paid equally across the year, so we won’t get the full 4%, 5% or 6% until we get to 31^st December 2023. At the same time, markets are ever moving, so valuation changes mask the fact that small slivers of that income are trickling in every day.

On performance generally, Q1 2023 was a positive quarter, with the range returning between 0.92% (Very Low) and 4.17% (High) depending on the risk profile selected. The portfolios also generally performed ahead of their benchmarks for the second quarter in a row, something we believe reflects the activity and changes we made last year when markets were volatile.

Perhaps the most pleasing part of the results is that they were delivered in a difficult environment. In that respect whilst the numbers reached our return objectives for the quarter, we are still waiting for the portfolios to start to really deliver the potential we feel we have built. As the banking issues subside, and markets revert to looking at the core inflation trends, we remain positive that we will see the numbers continue to move in the right direction.

Market Outlook

We came into 2023 optimistic about the returns that can be delivered, and after the first quarter continue to share that optimism. At the same time, we expect market volatility to remain high because the economic environment is still a challenge, and the repercussions of the interest rate increases take time to bubble up to the surface.

One of those bubbles we are now seeing in the banking world, with a number of US regional banks facing liquidity and profitability problems. In the case of Credit Suisse, that was more of a business model issue, rather than a banking issue. To that banking point in particular, there are some key differentiators to the banking issues of old, the most important of which is regulation, which across Europe and in the major US banks is extremely tight. In the UK we have a ring-fencing of retail and investment banking activities, and around 95% of all cash deposits sit below the £85k per bank threshold, meaning they are covered by the Financial Services Compensation Scheme. Secondly the policy response has been extremely quick and comprehensive. Credit Suisse has been purchased by USB, and the US regulator has guaranteed all deposits at the banks that have been in trouble. They’ve seen this movie before, which makes it much easier to ensure a different outcome.

That isn’t to say there won’t be more news flow about other areas or sectors which are showing stress. After fourteen years of money being free, companies now face the prospect of restructuring at much higher interest rates, so doubtless there will be casualties. That’s normal though, especially at the point where economies are slowing or entering recession.

On the growth outlook, we expect economies to remain resilient although don’t rule out a short, shallow recession, especially in Europe. In the US, economists believe the chance of a light recession is around 60%. We think it’s more remote, and will likely be pushed into 2024. The energy issue everyone was worrying about has fallen into the background somewhat, and as those prices and others fall away into the summer months, people will regain some confidence that the worst is behind us.

We expected inflation to come down quickly before the banking news, and this news has further enhanced our view. One of the outcomes from the banking stress is that naturally this leads to a more restrictive lending environment. Our base case therefore is that interest rates have either peaked already or have one small final jump to go. Inflation should be close to 3% by the end of the year, notwithstanding any changes in war trajectory or unforeseen events.

What does all this mean for future returns then? Well, it won’t be a one-way street, but the biggest reason for our positivity is that it doesn’t have to be great for clients to get a strong outcome. Q1 is a good example – it wasn’t without its challenges, but the portfolios still delivered between 1% and 3% in 3 months, with little contribution from capital growth. The income yield that we have in our portfolios is providing a consistent stream of returns between 4% and 7% per annum, so any additional capital growth will simply provide a further bonus.

The outlook for economies and markets isn’t that bad either. Once interest rates have peaked and inflation shows further signs of coming down, policy will have a clearer forward path and consumers can regain confidence. There are still risks and we expect wobbles, but with income returns continuing to trickle in each month, we expect to be able to build on the start to 2023 across the remainder of it.