DB Wood Team
7th October, 2022
Blog, IC Insights
Q3 2022 Investment Review
We often write to dumb down some of the financial market commentary, which tends to be provocative to generate more views and clicks. In the context of the last few months though, the media probably haven’t done enough to highlight some of the extreme moves that have been occurring.
Starting with the big picture, we remain in a world of trying to control inflation. Central Banks are raising interest rates, and governments are starting to roll out fiscal support, a strange policy mix that is causing uncertainty and correspondingly, big price moves.
To specifically highlight the situation in the UK over the last few weeks, the governments’ tax cuts and energy bill have caused concern in the international community about how the UK is going to pay back all its debt. Investors therefore demand a higher level of compensation for the risk they are taking, causing Government Bond yields to rise sharply and the pound to fall.
To put the moves in context, as of September 23rd (the day of the mini-budget), a 10-year UK Government Bond offered a yield of 3.1% (already much higher than the 0.97% available on 1st January). By September 27th, that yield had increased to 4.5%, reflecting a 14% capital loss in just 8 trading sessions. The chart below shows the journey across 2022 for the pound (vs the dollar) and UK Government Bonds. In short, the former has lost 21.28% against the dollar this year, and the latter 37% of its value.
There are of course opportunities created by such huge moves (which we will discuss in our outlook), though the point here is to illustrate some of the volatility present in markets across recent months.
As far as equity markets are concerned, in our last review at the end of June we discussed the likelihood of a summer bounce given very negative sentiment and the possibility for economic data to hold up better than investors were expecting. At the same time we did not expect any such bounce to be sustained, mainly because for markets to fully regain confidence we need to see persistent evidence of lower inflation rates. That was never likely until at least Q4, with the environment evolving as we expected – equity markets rallied into early August before moving lower once again. The net effect across the quarter was that the FTSE 100 lost 2.72%, other global markets also struggled, and bond markets fell further, with UK Gilts losing more than 10%.
To summarise then, Q3 mostly saw a continuation of 2022s trends: persistently higher inflation and weakness in equity and bonds markets. Here at home we had a magnified version of events given the fiscal announcements, with some unprecedented market moves across UK assets. We still need to see an improvement in inflation trends for markets to gain real confidence, though there is a silver lining in the meantime, which makes it worth waiting for.
In times of market stress, our objectives are two-fold. In the first instance we focus on ensuring the portfolios are invested responsibly. That means targeting economies, sectors, and business models that we deem as high quality, meaning that they should be resilient in difficult times. Secondly, we aim to take advantage of opportunities, progressively adding to areas where we feel the risk-reward relationship is skewed in your favour. Here we are looking for good value opportunities, and in this current market, those which offer strong income returns.
An example of that risk-reward balance is within UK bond markets. In the previous section we outlined the significant fall in value within that asset class so far this year, though the flip side of that is the opportunity to own them now is compelling. At this point it is worth reinforcing that a year ago today, the income provided by high-quality bonds in the UK was around 2% per annum. Now 7% per annum is reasonably easy to come by. That’s a monumental change and would require things to get significantly worse than they already are for your return to be negative over the next 12 months. Whilst we can’t say for sure that won’t happen, a realistic assumption would be somewhere between +3% and +10% for the next 12 months from that asset class.
Similarly, across equities, valuations look cheap. Higher dividend yields once again provide a better underpin of returns, with the potential for significant growth on top of that once the environment improves. Its not true in all cases, but certain equity sectors could rally by 20-30% and still not look expensive. For that to happen sentiment will need to come back though, so it is of course, much less certain.
In terms of activity, we have been reconstructing our portfolio heavily as asset markets digest inflation and a world of higher, albeit still relatively low, interest rates. The assets that brought us strong returns in the pandemic are not the ones that will bring strong returns in this environment. The opportunity set now is very different, similar in some ways to the financial crises of 2008, though this time the banks are in much better shape.
It should be noted that most markets were at 12 month lows as of September 30th 2022. We have been adding to positions as they improved in value (fell further), so although the short-term numbers are disappointing, the values on portfolios only reflect the current price to sell, and that is not the short-term objective.
The performance table displays the return journey across previous years. You will note that over the longer term our performance across our portfolio’s is consistently well above benchmarks. This reflects our philosophy to be active in times of market stress. In the right hand column, you will see the returns generated since the inception of the portfolios, and specifically can note a large differential between each risk profile and its benchmark.
Looking forwards, our portfolios now offer a built-in income stream that in itself should provide 4.5% more income from now on when compared to the end of December last year. If your annual withdrawals are less than 5.5% per annum, that means you are only spending the income distributed which all else equal, should leave the capital value intact. If on the other hand you are still in the accumulation phase, now represents an excellent time to be adding to the portfolio, with a very high chance of a strong return outcome 3-5 years in the future.
There is no doubt this has been a tough year, though the portfolios are now in a position to benefit from good levels of income whilst retaining capital growth potential that is substantially higher than it has been for most of the last decade.
The market environment from 2008 to 2021 was one in which asset prices grew substantially. This happened despite cyclical set-backs such as the euro crisis, trade wars, and more recently the Covid crash. As that period grew old, asset prices became progressively more expensive, and when capital values increase, the annual income (the ‘yield’) provided by that investment, decreases. Moreover, as prices rise, it is hard to see how they might grow further, and if there is only a limited income reward for ownership, there is little downside protection for when capital values fall. Since 2017 in particular, assets have been extended in valuation and in many respects, discounted from fundamentals.
The catalyst for this year’s reset has been the inflation spike, though in many ways the fact it has happened is more important than why it has. If interest rates are at 0%, companies can borrow huge amounts to facilitate growth, even if their business models or competitive advantages aren’t sound. At the same time, bonds were only offering 1-2% in income returns, causing investors to take more and more risk to generate 4%, 5%, 6% + returns.
This years’ drawdowns have been extremely tough, though it has been an environment we have needed in order to set-up the foundation for future returns. We did not expect inflation to rise so fast so quickly. However, a combination of the liquidity pumped into the global economy during Covid and the supply chain disruptions that followed, together with the war in Ukraine, provided a wall of support for rapidly rising prices. Capital markets have now had to discount the effects of higher inflation in their valuation metrics, resulting in market falls across both equities and bonds.
As we have talked about in recent blogs however, it’s really important to emphasise that the re-emergence of “income” as a key source of your return is a game changer. This has not been the case since the early 2010’s and the impact of an additional 4-5% per annum in income when compared to where we were at the start of the year is an additional 40-50% over the coming 10 years. As discussed in the review section, we have been rotating the portfolio accordingly to take advantage of it, and as an example, at the close of Q3 our low-risk portfolio was yielding 5.6% per annum, offering a great long term underpin to returns.
Economically things remain challenging. Inflation is yet to come down meaningfully, and that will be required to enable Central Banks to end their interest rate hiking cycle. Europe in particular looks to be in for a tough 6-12 months, with a near nailed-on recession, and the war in Ukraine continues to take twists and turns which provides additional uncertainty.
At the same time, it is also true that only a few things need to fall into place for things to improve meaningfully. A couple of lower US inflation numbers would be the easy example, giving markets confidence they are through the worst. Similarly, we could see progress in Ukraine or a loosening of Covid restrictions in China after their key political meetings in October.
From a portfolio perspective, we remain overweight in the US, as it looks the most resilient economy and is more isolated from the geopolitical challenges. Comparatively, we are underweight the UK, outside of the large-cap FTSE 100 index which should benefit from a weaker pound and provides us with commodity exposure which continues to show favourable long term supply-demand imbalances. Our equity bucket is also “high-quality”, which means high levels of cash generation, low leverage, strong market share and high barriers to entry. In many ways the longer and worse the environment is, the better those dominant businesses should perform relative to their lower quality competition.
It also won’t surprise you that we have moved from being underweight bonds to overweight, a key reason why the income yield on the lower risk portfolios is now above 5% per annum. Finally, since the UK policy announcements in recent weeks we have been reducing our commercial property exposure, which to this point has been performing well but now has to face a much higher interest rate environment.
All-together, the backdrop is challenging economically but from a future return’s perspective it looks very attractive. We have highlighted a number of things that could improve the outlook, but how long it takes for any of them to come through remains unpredictable. Patience remains the name of the game in the meantime, and although that can be a challenge in itself, given the volume of negative newsflow, its worth remembering that the portfolios are invested in high-quality assets with a strong level of income now underpinning your forward returns.