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January saw markets on good form. The nasty 2022 was in the rear-view mirror and an early dose of optimism was bubbling up to the surface, driven by the feeling that central banks were coming to the end of their rate rising cycle and that inflation would be drifting back to something more ‘normal’ in the not-too-distant future. Then things changed. The events that saw insolvencies in several US regional banks and the takeover of Credit Suisse by UBS in conjunction with central banks continuing to raise interest rates, brought a sharp dose of reality to the fore. Despite a wobbly few weeks, however, the market reaction has been surprisingly muted. The FTSE 100 started the year at 7451 and finished the quarter at 7631. Wall Street shrugged off its local difficulties too, so did the Euro Stoxx 50, both finishing up on the quarter.

Financial markets are caught between the two narratives of a soft(ish) landing (helped by China’s reopening too) and troublesome, sticky inflation that is keeping policy rates higher. As we continue to move through this tricky first half of the year and seemingly past the stresses caused in the banking sector, the negative news flow and continued persistence of inflation are both likely to abate. Whilst we’ve been among many to argue that there are better times ahead, markets remain very much in late winter, rather than spring.

Central Banks: Tighten Up. I’m achin’ now, I’m achin’ now; It’s times like these I need relief

With the effect of interest rate rises taking time to feed through to an economy and a banking system likely to go through a period of lending caution, more real-world impacts are likely, we’re beginning to see the impact of the profound tightening of policy that central banks have pushed through during the last 14 months or so. It is worth reminding how far we’ve come. Since January 2022, the US Federal Reserve has moved its policy rate from a hyper-low 0.25% to 5.0%, following the latest 0.25% increase in its March meeting. The Bank of England has also risen rates strongly over the same period, from 0.25% (although the rate rising cycle started in December 2021, from a low of 0.1%) to 4.25% today. Even the ECB, bearing in mind serious people were arguing not so long ago that it wouldn’t be able to raise rates before we fall into the next recession, has moved its deposit rate from -0.5% to 3% and it is fair to say it is behind both the Federal Reserve and the Bank of England in its base rate adjustments.

Central banks have been looking to feint markets higher in their pricing of what they anticipate markets to be. The US Federal Reserve has led the charge, metronomically banging its drum, trying to entice markets into a drumbeat stupor to take seriously their ‘higher and higher’ rhetoric. In the UK, the Bank of England has maintained its forward guidance credibility adding at least a violin section to soften the tone. With all the musicality of a skulk of screaming foxes, the ECB maintain its higher for longer narrative. As all sensible people do, markets have donned ear-defenders.

Central banks have plenty of tools to deal with the matters separately, containing the bank risks with support packages, mergers and liquidity, whilst using interest rates to combat inflation. These twin aims are not mutually exclusive and will likely result in lower peaks in interest rates than markets were anticipating just a few weeks ago.

It’s all gone Minestrone

I’m a fan of the Italian soup; tomatoes, plenty of veg, some beans and a dose of pasta. An excellent way to feast at lunch. Tinned is fine, no need for the fancy stuff.

What I’m now less a fan of is the price. “Premium” brands sit on your supermarket shelf at an eye watering £1.70, your supermarket-own version comes in at a far more enjoyable £0.60. To my mind, there’s more than a whiff of profiteering underway when a tin of soup goes from less than a £1 to £1.70 in short order. Other examples of a pushing up of profits can be seen in some sectors such as US retail, where profits surged last year or in Europe where the ECB recently highlighted that profit expansion amongst European companies warranted as much attention as rising wages in their fight against inflation.

There’s more than a whiff (and data) that price hikes are being pushed through by some suppliers, producers and service providers above and beyond those just covering costs. Rising prices driven by profit-led “greedflation” can eventually be taken down by central banks reducing the disposable income of consumers through rate-rises, though this is an inefficient method. Once media headlines about a ‘cost of living crisis’ subside, removing the cloak of darkness for retailers to push through profit-led price rises, consumer tolerance will fall quickly as both ability and willingness to pay evaporate amongst the largest falls in real wages since records began in 2001.

Inflation – Long way down

Two steps forward, one step back still gets you moving in the right direction, albeit with a high degree of frustration. That’s where we find ourselves in the outlook for inflation. We’re all desperate for a nice and quick path back to a low inflation environment, but we’re by no means there yet.

We are surfing the third inflation wave. The first wave, goods inflation, was driven by supply constraints as countries and companies emerged out of lockdown and there was a clamour for “stuff”. In the UK, this peaked last October but in the run up to that peaking, the second wave hit as a result of the war in Ukraine as both energy and food costs spiked. This will begin to roll out of the annual numbers in the coming months (oil and natural gas prices are now well below the level they were at the onset on the invasion). The third, shallower, wave has been the rising level of services inflation, think pubs, restaurants, and hotels.

Source: Office for National Statistics, HFMC Wealth

It’s important to hold on to the big picture, which is that this year we are going to see inflation falling and the pace of that decline is likely to steepen, particularly as the quarterly energy price cap is predicted to fall through the year. That’s good news, but it still feels a long way down and some time before we get to levels at which we can all feel a little bit more comfortable and central banks can release themselves from their hawkish tones. While food price rises ease and energy costs fall should see inflation fall back to mid-single digits, getting to central bank target rates will take longer but will be tolerated as other events, such as those in the banking sector, drag forward the time to pause.

Banks – What have the Romans Banks ever done for us?

The scene in Monty Pythons Life of Brian, involving Reg questioning what the [occupying] Romans have ever done for us, only to be confronted with a long list of benefits (aqueduct, wine, public order), echo how banks have been tolerated, rather than accepted, since the financial crisis. The latest events in the banking sector and their ramifications when it comes to the important role banks fill in financing commercial enterprise, will remind us that a healthy and strong banking system help promote a healthy and strong economy.

Consumers are the main driving force of growth in the US and UK economies. Since the pandemic, US consumers flush with dollars sent straight from the government were happy to spend and then subsequently drive down their accumulated savings. Stresses are beginning to emerge as the personal savings rate has fallen well below pre-pandemic levels. Mortgage applications have fallen in the US and rising credit card balances have increasingly been taking the strain, reaching almost $1tn of outstanding credit card debt.

In the UK, the relentless headlines of a cost-of-living crisis have made for a more cautious consumer, who is better served to weather economic chills. The rate of household savings is still above the pre-pandemic years and bank deposits are also at highs. In the UK however, the minority with mortgages are still living with the fallout from the Liz Truss/Kwasi Kwarteng budget and the shock that had to mortgage interest rates, which will continue to impact those with old fixed rate deals as they roll off and need to be refinanced.

What is not yet known is the level of impact the insolvencies in the US regional banking sector and the takeover of Credit Suisse by UBS will have on the appetite for banks to continue lending and at what rate. It isn’t unrealistic to begin presuming that banks will be more cautious when it comes to providing loans to businesses and households. This reduced flow of credit into the economy, will work with central bank tightening to help to constrain demand and appetite for borrowing, especially if there’s an albeit diminishing concern about savings in banks.

Growth and Inflation Numbers:

Thanks, as ever, to our friends at Schroders for the latest consensus forecasts, which are:

Source: Schroders Talking Point

As discussed above, the real economy is in for a hard time during this year. The threat of stricter lending policies resulting from the recent banking failures and their impact on the broader economic scene are as yet unknown, and certainly won’t be included in the above numbers.

Looking at longer term expectations for inflation helps frame the ability to adopt patience when inflation remains so stubborn. The Bank of England anticipates inflation of 3% this time next year and 1.5% for 2024; the Office for Budget Responsibility forecasts a very similar ending point this year, but then for the middle years of this decade is forecasting inflation below the Bank of England target rate, not returning to target until 2028. Yesterday’s news is tomorrow’s fish and chip paper as Elvis Costello and The Attractions once said!

Portfolio Outlook

In fixed income markets, 2023 has seen a marked shift from 2022. Bond yields have moved lower (& prices risen), reinstating their diversification benefits in portfolios, which is welcome. We continue to use several strategic bond funds, some of which have been slowly increasing interest rate sensitivity in portfolios, in anticipation of falling interest rates. The yield available from fixed income, whether it be government of corporate bonds also serves as a positive, long-term backdrop. In recent years, defaults have been kept very low as pandemic support kept businesses going and ultra-low interest rates made debt servicing very cheap. We need to be aware that defaults will likely rise as companies refinance at higher interest rates.

In equity markets, valuations still look attractive after a miserable 2022. This makes prospective long-term returns from equities look more positive than they have been for some time. Whilst valuations steadily fell through 2022; areas such as US equities really only saw their valuation move from ‘expensive’ to ‘average’. Others, particularly the UK and Japan are looking cheap versus history, but both require a catalyst to unlock that value. Pressure on corporate earnings and profits will grow as consumer spending pressures build.

Broadly, we remain comfortable with the asset allocation and fund selection in portfolios and are more optimistic for future positive returns than we have been for some time. In the Core Cautious, we reduced some cash and money market holdings to increase fixed income allocations. We did the same in Core Conservative and also switched Baillie Gifford International to Baillie Gifford Global Income Growth, for its focus on dividend paying companies. In Core Balanced and Aggressive portfolios we added to JPM Natural Resources. In the Income model, we increased fixed income and switched from Fidelity Index World to Fidelity Global Dividend and Baillie Gifford Global Income Growth.

All other portfolios remain unchanged.

We are fast running into a period of falling inflation and less aggressive central bank policy, which are ultimately favourable backdrops for the long-term investor faced with more attractive asset class valuations than we’ve seen for some years. In the near term though, headwinds from this crisis in confidence and slow economic growth remain.

Conclusion:

Since the beginning of February some of the early-year market enthusiasm has disappeared from the market. The relentless tone coming out from central banks that interest rates are going higher and higher and higher, is a burden that markets are still struggling to digest. Matters such as the insolvency of some US regional banks, add to the level of uncertainty and risks.

Having said that, the first part of this year was always going to be a tough. In the last Investment Strategy, we concluded that we are not entering 2023 with a hop, a skip and a jump as much of the impact of what happened during 2022 is yet to be felt in the real world. The emergence of that pressure into the real world is what we are seeing today.

There are a number of equity markets where valuations don’t look particularly challenging, from which patient investors should be able to achieve decent long-term returns. The same can be said for fixed income markets (for the first time in over a decade) which have seen yields rise significantly since the beginning of 2022 and can now do two things. First, they can deliver a headline level of yield which warrants attention and a place in portfolios. Second, they should be able to return to that previous role, which was to serve as an offset to the equity market risk.

We are not blind to these economically tough times, nor the likely pressure this will bring on corporate earnings, nor the numerous geopolitical risks still to be navigated. Now is the time to be even handed, rather than get swept along in a wave of bear market negativity. 2022 was tough because financial markets are discounting mechanisms after all. Like the weather outside, we may not be in high summer, but we’re not in dark winter either. Time and patience remain an investors best friend.

From all of us in the investment team, Emma, Will, Becky, Kim, Hayley and me, we thank you for continuing to place your trust in us in managing your portfolio.

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The table below shows Investment Association sector average returns broken down by asset class and geography, this time in sterling. The US dollar was strong in 2022 vs. sterling, yen and euro but there has been a step change in Q1 ’23 and sterling has found favour.

Data from FE Analytics

Most asset classes thrived in the first quarter of 2023. North American equities and UK direct property, both of whom found themselves at the bottom of the table last quarter, remained at the bottom of the pile while Europe excl. UK equities, had another poll position quarter finish in low double-digit territory. Index-Linked Gilts swapped its second to bottom place from last quarter to second to top this quarter.

The following table shows the winners and losers in terms of the industrial sector for the quarter in local currency:

Data from FE Analytics

Sectors that have been the darlings over the last decade returned to the spotlight, with technology and consumer discretionary (which hides within it names such as Tesla and Amazon), were the only sectors to produce double-digit returns over the quarter. Old economy sectors, those that have not advanced significantly from a technology perspective, were relegated to the bottom of the table.

There has been a notable style switch in the first quarter of 2023, with ‘growth’ as an investment style significantly outperforming ‘value’. Growth stocks, which have been leading markets for the last decade, fell out of favour in the last quarter of ‘22 but have enjoyed a return to the limelight.

Fixed Income

It has been a volatile quarter for fixed income and index-linkers particularly, who finished the quarter in positive territory, a reversal from the previous quarter. We continue to use strategic bonds but have reduced short-dated fixed income funds and have tentatively started to increase duration; the fall in fixed income markets provided an opportunity to add to select pockets of value within fixed income.

Currencies

Sterling reigned supreme in the first quarter of 2023. Whilst the story of 2022 was a strong US dollar, particularly against sterling, year to date sterling is en vogue.

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There are some specific issues related to SVB, which became insolvent in March (another bank, Signature Bank, was also closed by New York State Regulators):

So, what happened at SVB?

• SVB had grown its depositor base very quickly – quadrupling the amount of deposits over the last five years. This was coming from, in a large part, venture capital backed start-up companies who when venture capital backing became more cautious, increasingly drew down their cash deposits.
• SVB had a large amount of uninsured deposits within its customer base, they were not a retail focussed bank, which meant the client base was therefore much more flighty. Worries about lending quality and the level of crypto deposits saw depositors seek to withdraw their cash, which in turn saw SVB need to sell down assets to pay depositors.
• SVB, like all other banks, held assets and SVB held a large proportion of these in US Treasuries. So far, so good. The “but” comes from what type of Treasuries they held, which were long-dated maturities, those most sensitive to losing value if interest rates rose. As interest rates did rise, these bonds fell in value and as depositors sped up with withdrawal of cash, SVB needed to sell some of these Treasuries to fund those withdrawals.
• When SVB announced it was selling $21bn of these Treasuries at a $1.8bn loss and was also seeking an equity raise of $2.25bn, depositors got even more concerned, and a bank run ensued. The attempted equity raise got pulled after SVB’s share price fell 60% and the FDIC took over the bank.

In terms of a response, the regulatory authorities have been quick to act:

US response:

1. For all depositors in Signature & SVB, the US authorities guaranteed access to their deposits (not just those that were insured against bank failure – in the US, this is deposits <$250,0000).
2. A new bank term funding programme was made available to all banks, allowing them to raise cash against the maturity price (not the lower market price) of high-quality assets, such as US Treasuries.
3. Shortly after the failure of SVB, 11 major US banking giants such as JPM, Bank of America and Citigroup agreed to deposit $30bn in another struggling US regional bank, First Republic, to help not only shore it up, but also send a signal of confidence in the US banking system.

UK response: SVB UK was bought by HSBC for £1, who injected £2bn into the bank. This meant depositors also continued to have access to funds.

Enter stage right, the unwitting Credit Suisse…

Credit Suisse has been taken over by its Swiss rival, UBS, in a regulator-backed transaction borne out of the experiences learned during the financial crisis, from which regulators learned:

• To act fast
• To go big

Credit Suisse is/was a much bigger fish than SVB; a major European bank judged to be of sufficient size to be considered a global, systemically important bank. It has, however, had a difficult ride in recent years within its investment banking, wealth management and asset management divisions and seen its market cap decline significantly. Had it not been for SVB, Credit Suisse could realistically be talking about its turnaround strategy, having recently raised equity capital from investors, in the expectation that ‘the market’ would be giving it the benefit of the doubt. Instead, bank runs in the US, delays to its financial reporting and an “absolutely not” comment from one of its equity backers that it wouldn’t support with more equity investment (the bit about that being for regulatory reasons, rather than investment reasons being bypassed by headline writers), left Credit Suisse looking like the soft underbelly of a European banking sector at a point of financial stress.

In terms of what has happened:

• Equity investors in Credit Suisse have had 22.48 shares exchanged for 1 UBS share, equivalent to just CHF 0.76 per share. No shareholder approval was required.
• UBS have CHF25 billion of downside protection, notably including a lower tier of Credit Suisse bonds (called AT1’s) that have been written down to zero; CHF 9 billion in loss protection (after the first CHF 5bn in losses), as well as a “very significant” liquidity support provided by the Swiss National Bank.
• Central banks have coordinated to extend international liquidity for US dollars.

What now?

The regulatory actions have been pretty decisive in both the US and Europe. In the US, if further banks hit similar troubles, they too are likely to have particular niche characteristics and now have a defined pathway to go down. Lessons from the global financial crisis point to governments and regulators increasing the level of support until the market hawks see that as an insurmountable fact. The actions around Credit Suisse will be testing the water if that is now the case. In the near term, the answer is ‘yes’, in the longer term, the jury is still out.

The banking sector is a vastly different sector than it was in 2008. Regulators have far more tools to deal with situations like this and the recent actions show matters like this can be dealt with in swift order. In 2008, a large part of the problem was opacity and limited knowledge on how to value a host of bank’s more esoteric assets, as well as needing time to develop the tools to solve the problem. That isn’t the case today.

But spillovers can and do occur. These events will damage confidence and build uncertainty for at least the short term. This builds on the uncertainty that was already swirling about the continued level of interest rate rises being pushed on to the economic environment. It wouldn’t be surprising to see banks tighten their bank lending standards in the interim, which will stifle the flow of credit and pull back demand, increasing the risk of a recession it looked like potentially being avoided. Depositors too may take the opportunity to diversify their cash deposits over a broader number of institutions (potentially triggering more outflows out of some of the US smaller banks).

The events also put front and centre in the minds of central bankers, that there are now twin aims when considering interest rate rises. Inflation remains key, but so too does a watchful eye on the health of the financial system and the stress interest rate rises are creating.

These events should not be trivialised, but they also should not be seen as a systemic risk to the banking sector, as it was in the global financial crisis. Think of this as being the confluence of two rivers; on the one hand, some lesser regulated US regional banks, with particular characteristics and susceptibilities, met the long-term managed decline of a major European bank. In these turbulent waters, all parties were subsumed.

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In the time it took the FTSE 100 to go from 7000 to 8000, excluding dividends, the US market (shown in green below) rose far more significantly, almost doubling over the same time, whereas the poor old FTSE 100 investor, in stumbling over the 8-years in getting to 8000, received an almost snail-like return of 1.7% per annum at a headline index level.

But what about those valuable dividends, I hear you cry? Well, yes, that has absolutely made a difference. Sticking in local currency terms for now, the healthy dividends that UK companies have traditionally delivered, has thankfully helped investors in the UK market to a slightly more respectable annual return of 5.6% assuming those dividends were reinvested. Comparing this to other global markets, the US remains head and shoulders above other markets, but the FTSE 100 has actually delivered a return slightly ahead of European, Japanese and Emerging Markets equities, when dividends are taken into account.

So, maybe UK equities haven’t been a lost case after all? Well, we all know that is the case because we can see it in portfolios and look in the ‘returns’ column, so what else is going on? If you are a UK based investor holding overseas assets, then assuming you aren’t hedging currency fluctuations, your return will come from the price movement of the asset you hold and from the difference between sterling and the overseas currency. A weak sterling increases the return from holding overseas assets and a weak sterling we’ve had. The chart below shows how when you take into account currency movements, returns from the same equity markets, boosting their returns and putting the FTSE 100 back down at the bottom of the league table.

Unloved and Unwanted

Since 2015, there have been some major headwinds for UK assets more broadly. First, an uncertain political backdrop in the years since the EU Referendum. From the initial vote in 2016, through the fractious negotiations between not only the EU and the UK, but also within the Conservative Party, particularly during the May Premiership, all conspired to diminish the attractiveness of UK assets for overseas investors. This heightened political risk associated with UK assets meant, for many overseas investors, the UK market was filed away in the ‘too tricky to worry about box’ and they were happy to reallocate elsewhere.

But the move away from UK equities was already well underway. The reduction of UK equities as part of the asset mix within UK defined contribution corporate pensions can be traced back to the beginning of the millenium, where it was typical to not only have a high percentage invested in equities but for this to be predominantly UK equities with only a relatively small amount in overseas equity markets. The losses suffered in equity markets from the ‘dot-com’ era, saw equity allocations reduce. This sped up in the years following the global financial crisis as the bank heavy FTSE 100, found itself out of favour and the gradual reduction of UK equities continued from the portfolios of UK investors. The decade or so since the Global Financial Crisis, saw US equities increasingly in favour as ‘tech’ was in, and again, the UK market with its energy, resources and financials, found it mis-positioned to attract investors who increasingly applied an ESG overlay (environment, social and governance).

2022 saw a better return for the UK market, but the relentless torrent of investors giving up on UK assets continued. According to Morningstar, £12.6bn was taken out of UK Large Caps during 2022, approximately £2.5bn out of multi-cap and equity income funds and £3bn out of UK Small Caps.

So where do we sit today? UK equities remain unloved by global asset allocators, but with the US equity market giving domestic investors a bloody nose in 2022, for the first time in many years, it is not uncommon to hear US market commentators highlight the value that can now be found outside US markets.

UK equity markets look cheap versus their own history at c10x forward price/earnings ratio. They also look relatively cheap versus US and European markets, whilst offering one of the highest dividends of any market and that’s before any share buybacks are accounted for. With a sector composition that all of a sudden seems to chime more with the global rhetoric of energy security and a declining political hangover, we could just be entering into a more favourable backdrop for our domestic market.

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Just before Christmas, The Economist ran an article charting the decline of Britain compared to a group of other countries (including the US, France and Germany amongst others) which showed since the onset of the financial crisis in 2007, GDP per person (adjusted to neutralise currency strengths/weakness) was the lowest of its peers, as was the productivity of the British workforce over the same period. Part of the reason for the decline in productivity has been levelled at falling numbers of over 50’s in work and the rising numbers of those classed as “inactive”, both of which moved in opposite directions at the beginning of the pandemic in early 2020.

Blowin’ In The Wind

In the early days of the pandemic, it was younger workers who found themselves economically inactive[i] as the bars, restaurants and the gig economy shut down. However, the long-term trend that emerged through the next couple of years was the primary group of workers leaving the workforce were those aged 50-64 (the pink/salmon section of the bar in the chart below).

[i] “People not in employment who have not been seeking work within the last 4 weeks and/or are unable to start work within the next 2 weeks.” Office for National Statistics Definition

Since January 2020 within the 50-64 cohort, the number of non-working individuals rose from 37,000 to 386,000 by July 2022, before dropping back to 302,000 by the end of October. Whereas, in the 16-24 age group, whilst there were initially just under 6,000 economically inactive people in January 2020, the numbers ballooned to c290,000 in the three months between January and March 2021, just a year later. This subsequently fell back to 67,000 by the end of April 2022. It should also be noted the total number of people deemed economically inactive was still over 500,000 in the latest set of data[i].

In response to this, the government plans to encourage those who have left the workforce to have a ‘midlife MOT’, a health and wealth check. Presumably, the intention is to highlight how assumptions many may have made early in the pandemic may need to be reviewed given double-digit inflation and difficult investment conditions. Inflation isn’t an equal arbiter and neither is the necessity to work. Currently, the inflation driven by rising food, energy and rent costs, disproportionately impacts lower income workers as they spend a greater percentage of their disposable income in these areas.

[i]Throughout, I have heavily drawn on the data released in the ONS “Reasons for workers aged over 50 years leaving employment since the start of the coronavirus pandemic: wave 2”.

To read the full report click here

Handle with Care

Looking under the bonnet and into the numbers a little more, an MOT may bring some unwelcome news for those hoping for a swift return of many more experienced workers.

Whereas the majority of those closest to traditional retirement age, left work to retire or because they no longer wanted to work (64%), in the younger 50-54 age group, just 16% shared those same motivators. In fact, half of the 50–54 year old workers, who left paid work, did so due to either stress, illness, mental health reasons or disability, rather than leaving from a position of financial strength. Only 38% felt they have the retirement provisions to meet their needs.

An overworked and under-resource NHS will play a key part in returning these workers to the economy – and with it an £8 billion production boost to the UK economy[i]. With the NHS being short of almost 50,000 nurses, 12% job vacancy rates and a 7.2 million backlog in the waiting list queue, the solution won’t be quick.

[i] According to the Institute for Public Policy Research, who estimated approx. 1/3 of workers who have left the workforce since the pandemic was for health-related reasons and sought to calculate the economic impact. IPPR, Health & Prosperity Report, April 2022

Ain’t going to work on Rishi’s farm no more

Weak wage bargaining power remains prevalent, despite an increase in unions taking workers out on strike. The percentage of British workers who are in a union is currently only about 25% of the workforce, whereas this peaked in the early 1980s at around 50%. Tougher legislation has contributed to a decline in union power since and looking at a chart showing how many days had been lost due to strike action, the most striking feature is just how passive labour has been over the last 30 years or so. Rising costs have brought into sharp focus the reality of sub-inflation pay rounds, and a more determined public sector workforce determined to have their voice heard resulting in a ballooning in the total number of days lost due to strikes to rival any of the millennium, with the exception of 2011.

Source: Office for National Statistics

Not dark yet

Britain is set to have amongst the lowest growth in major economies this year and tackling the UK’s productivity gap will take a multi-faceted and long-term approach. I’m keeping a straight face when I say Liz Truss had a point – we do need growth and we do need to tackle the ‘levelling up agenda’ which stretches far beyond a political strapline to impact the health, wealth, happiness and life expectancies of all Britons. Why should someone born in Blackpool have a healthy life expectancy of 56, but someone in Richmond upon Thames have one nearing 70? We just can’t borrow our way all the way there.

A dear former colleague always said you shouldn’t deliver problems but should deliver solutions to the problem identified. There is no one solution, let alone an MOT, that will drive the changes required. The root causes and required reforms will drill down into the country’s health and education systems, its overly centralised form of government, it’s social care provisioning as well as an economy dominated by its southeastern quadrant. And yes, some personal ownership too.

The solutions do not belong in these pages, but they will (or should) be found in the pages of the manifestos for government at the next election.

Views and opinions are my own and not of any organisation I may or may not be associated with in a professional or personal capacity.

Last year was an incredibly challenging year and brought folly to most market newsletters within just a few short weeks and so it is with slightly more nervous trepidation than usual, that I set out our thoughts for the year ahead. 2022 threw everything at us; a slowdown in economic growth, a surge in inflation; the fastest pace of interest rate rises since the 1980’s in the States; an invasion of a sovereign, independent European country; three Prime Ministers, four Chancellors, one of whom sparked a crash in the Gilt market and, oh yes, a World Cup in winter.

A quieter 2023 is on everyone’s New Year’s wish lists.

January delivers a catharsis, a purge of negativity, and a chance to have a refreshed look at the world and the portfolios we manage on your behalf. “Pivot” is becoming an overused word in most investment commentaries, whether it be central banks, chancellors, or us investment folk. Things getting ‘less bad’ isn’t usually a cause for celebration, but with all the trials that 2022 brought, some relative relief that a difficult year has passed is something to hold your hat to. Bad years come and bad years go, often leaving the opportunity of depressed markets for those long-term investors who can look through such periods of challenge.

Tough sledging on Main Street

For now, we remain in an economic environment that is seeing consumers having to spend down savings or take on debt to counter an incredibly hostile wage backdrop of negative income growth. The squeeze in incomes is particularly acute but feeds into a longer-term story stretching back to the beginning of the millennium, which has seen a declining amount of corporate post-tax profits going to the labour force as corporate profits have expanded.

Source: Bank of England, Consumer Credit Flows

The spending power people have from earned income is collapsing, which has combined with decades of declining trade union membership as well as government policies, such as zero-hour contracts to undermine the collective (or individual) bargaining power of labour.

In a low-inflation, low interest rate world, the drip-drip effect of wages very slowly drifting behind inflation can be absorbed, like it was in the years that followed the global financial crisis when between 2008-13, wages fell behind inflation. US and UK consumers have frequently been happy to continue buying stuff they don’t really need with money they don’t really have as long as they have a job. This was particularly the case when cheap loans, 0% interest deals abounded and debt-servicing costs collapsed. We are now at a pressure point, with inflation at multi-decade highs, acute real terms wage falls, and interest rates at levels outside the conscious memories of many younger workers. This challenging outlook is compounded by the prospect of a steady stream of low interest mortgage deals requiring re-financing at higher rates in the coming years (or in the US a reluctance to move as doing so would trigger giving up long-term, low interest rate mortgages).

All this is set to further undermine consumer confidence from an already weak position but, for now at least, the unemployment picture remains relatively benign. Much of the outlook for the real economy will be how hostile the jobs market becomes, and the number of vacancies in the UK economy is already beginning to roll over.

2023 – It’s Goodnight from Me and Goodnight from Him

The Two Ronnies comedy sketch show seemingly ran for about 150 years of the twentieth century, being repeated twice a day, every day for the entire 1980’s. Despite saturating TV scheduling, there were some notable sketches, one standout being the Mastermind sketch, with Ronnie Corbett choosing to “Answer the Question Before Last”. A quick Google search and YouTube link will raise a chuckle or two through early January…

Throughout 2022, markets too were searching, but couldn’t find answers to two key questions. First, when is inflation peaking? Second, when are central banks going to stop raising interest rates? 2022 delivered confused messages, 2023 is likely to clarify both and dare I say it, the chance of a pivot or two.

On inflation, there are early signs it is peaking in the US and tentative signs of something similar in the UK. As we work through 2023, the conveyor belt of time that compares prices from 12 months prior will see us move through the spike in energy prices from early 2022, and with it, inflation numbers should begin to fall. Inflationary forces across the economy aren’t uniform and don’t walk in lockstep and as the chart shows, US goods inflation (a large component here is new and used car prices) is already heavily falling and has been through most of last year. Falling goods and energy prices are the ‘quick wins’ of the disinflation story and will help push inflation lower during the early part of the year.

In the UK and even more so in Europe, the impact of rising energy costs has been more acutely felt given our reliance on external supply, particularly from Russia. Inflation across the service economy is more resilient and likely to persist in keeping inflation higher than policy rates through the course of this year. The outlook for wages and hiring intentions here will be key to how persistent inflation is throughout this year. In the UK, the outlook is being shaded by how employers react to a reducing pool of labour (emigration, ill-heath and a rising number of early retirees) may well encourage employers to hoard labour.

Clarity on this will emerge this year but we are not likely to see a return to something resembling a target policy rate of inflation until 2024.

U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: Nondurables in U.S. City Average [CUSR0000SAN], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CUSR0000SAN, December 16, 2022.

On interest rates, any rate changes take time to feed through to the economy and we have yet to witness the full impact of those that were pushed through during 2022. History suggests central banks tend to overtighten policy, resulting in an increased risk of a recession and 2023 is unlikely to prove any different. In the face of a weakening economy, the Bank of England is closing in on the end of its rate rising cycle, with smarter people than I believing 4% will be the peak rate, but then maintaining that through 2023. Members of the MPC have been at pains to talk markets down from the expectation of seeing interest rates in the region of 6% (which was the case after the Kwasi mini-budget) and have recently become more cautious with the tone of their comments when discussing future rate rises.

The US Federal Reserve Chair, Jerome Powell, is telling markets interest rates will need to go higher than they are pricing – undermining his own forward guidance earlier in the year is coming back to haunt him and has resulted in markets not believing him. Expect the Fed to start cutting rates in late ’23. The ECB, led by President Lagarde is looking positively hawkish, screaming for more and more rate rises.

By the end of this year, the newspaper headlines will be less focused on a cost-of-living crisis and more on a slowing economy. For ‘forward looking’ markets, much of this year’s distress on ‘main street’ was discounted through the course of 2022. In fixed income, whilst there were few places to hide, 2023 offers the prospect for a recovery as the rate rising cycle draws to its end. Fixed income markets are more relevant again as a source for providing the potential for attractive long-term returns. High single digit starting yields and the prospect of a more positive interest rate backdrop, plus relatively strong corporate balance sheets make us believe we will see a recovery in the early half of next year.

The mood in equity markets remains skittish, but the big picture is that valuations have become more attractive. Some have fallen from expensive to fair value, such as US equities, others particularly the UK and Japan are looking cheap versus history. Plenty of bad news was priced into markets through 2022, which makes prospective long-term returns from equities look attractive, particularly from those cheaper markets, albeit a further catalyst will be required to unlock this. Having said that, pressure on corporate earnings will grow. Wall Street analysts (usually a pretty happy bunch) start each year forecasting earnings growth of “high single digit/let’s call it 8%”, then spend most of the following year gradually revising these expectations lower. According to FactSet, for full year 2023, analysts are forecasting S&P 500 earnings growth of a more muted 5.1%. Worse still, if you strip out the energy sector for which they are anticipating another bumper year, the rest of the market posts negative earnings growth of -1.8%. We find greater comfort allocating to markets, such as the UK and Japan, that have more of a valuation safety net for now, whilst recognising the challenges they face.

China – Moving on

There has been an amazingly swift retrenchment from China’s zero-COVID policies with implications not only for China, its economy and the health of its citizens, but also for the prospect of better-than-expected global growth prospects in 2023.

Whether it be from political pressure served up by public protests against ongoing zero-COVID policies or whether the ending of so many restrictions was borne from the reality that the virus is already spreading through the majority of China’s cities, China’s zero-COVID policy became implausible to enforce. With relatively few elderlies fully vaccinated in comparison to the likes of the UK or US, the sudden removal of restrictions comes with risks. There are 25 million over-60s in China who have received no jabs and 58 million need a booster, with now only belated attempts to encourage the elderly to get jabbed. This doesn’t give confidence that preparations for a ‘living with COVID’ China have taken place, whether this is with vaccinations, stockpiling anti-viral drugs or preparing hospitals.

What appears now to be an almost rushed transition from zero-COVID to a ‘living with COVID’ policy, without planning or preparation for a re-opening, raises the prospect of a stressed healthcare system and a cautious to emerge population who have limited amounts of natural immunity and with it, sadly, many deaths. It’s likely to be a stressful transition phase, but the prospect of a quicker than expected return to normality, which if examples here and elsewhere offer any kind of guide, suggests consumers quickly return to the shops, cinemas and eateries.

There are other tensions in China that are being tackled by the government. In its property market, banks are being encouraged to finance property firms to complete building projects that have been suspended; tax breaks to encourage reinvestment of capital from property sales are in force until the end of next year and the central bank reduced the amount of capital banks were required to keep in reserve to facilitate increased lending to the sector. A slow, protracted unwind from China’s property bubble is in the ‘least worst’ outcome of options for government policymakers.

The near-term outlook for China remains bumpy and problematic and the risk from a disorderly exit from zero-COVID policies is likely to trump the longer-term positives of a supportive central bank, a government focused on re-starting growth and a re-emergence of a consumer spending populace.

Growth and Inflation Numbers:

Thanks, as ever, to our friends at Schroders for the latest consensus forecasts, which are:

As discussed above, the real economy is in for a hard time during this year. Slowing activity and rising costs will all weigh heavily on the economic outlook. Inflation will be falling – expect to see the word ‘disinflation’ becoming the investment commentary word of the year – but if the consensus is correct, it’s going to be a slow, stickier decline than we’d all hoped for.

A quick note regarding the level of GDP for the UK – this looks surprisingly strong. Surprise! It isn’t. It looks elevated because the ONS revised down previous forecasts and pulled that growth into 2022’s numbers. Overall, UK GDP is just reaching back to its pre-pandemic levels.

Portfolio Outlook

Broadly, we remain comfortable with the asset allocation and fund selection in portfolios and are more optimistic at the prospect of positive returns in future years than we have been for some time.

Some of our strategic bond managers spent 2022 increasing duration (taking the view that market yields will start falling, translating to positive returns) and a question we are asking ourselves is whether to increase this further at a portfolio level. In Cautious and Conservative models, we sold the most defensive fixed income fund, as we felt its role of providing protection in a volatile environment was complete and we rotated the proceeds across a select few existing funds.

Amongst other changes, we changed the Asian equity fund in Growth and Aggressive models, bringing in Fidelity Asia Pacific Opportunities. In the Income model, we replaced Fidelity Global Enhanced Income with its ‘sister’ fund, Fidelity Global Dividend, sacrificing some headline income for better long-term capital growth prospects.

Team News

We were delighted to see Emma Clarke, my Investment Manager colleague, selected as a finalist in the Fund Selector category at the Investment Week, Women in Investment Awards during the quarter. Reaching the final eight was a fantastic achievement and deserved recognition for Emma, who has been fundamental in deepening the level of our fund research since her joining.

We also welcome Will Redmond to the team, joining just as we entered the festive period. Will has spent three years working as a fund analyst at another wealth manager and he joins to bolster our team fund research resources.

Sell now, pay later.

The last few years have been marked by seismic events that have triggered large bouts of market volatility, most notably during the global economic shutdown of 2020, sparked by the onset of the pandemic. On such occasions, when portfolio returns fell by more than 10% during a quarter, we were obliged by our regulator to inform you of the drop. I’m pleased to say clients, with the stewardship of our consultants, have recognised that selling assets in the immediate aftermath of significant falls in value isn’t usually the best option, but inevitably these letters raised concerns.

No one likes to see portfolio falls in value, but in difficult years it is often more about surviving, dusting yourself down and being in a position to move forward again. These are, after all, long-term portfolios designed to meet your long-term requirements. The government has decided to remove the requirement to send ‘10% drop letters’ with effect from later this year, but has also confirmed they will take no action against firms who don’t issue letters in the period up to the rule formally ending.

Clearly, our chief hope and ambition is to not find portfolios down by such amounts but to ensure we remain to concentrate our efforts on portfolio management and in agreement with our colleagues in our compliance team, we’ve taken the decision to suspend issuing any 10% drop notifications from now on.

Conclusion:

We are not entering 2023 with a hop, a skip and a jump as much of the impact of what happened during 2022 is yet to be felt in the real world. The impact of central bank rate rises will come home to roost with many continuing to find rising bills and rising costs a huge challenge. The war in Ukraine weighs heavily over the energy supply complex, early signs that this winter’s storage facilities have been filled in Europe augurs well, but energy supply in 2023 will continue to be challenging and volatile.

As I said at outset, bad years come, and bad years go. 2022 saw some significant falls in value, but with it came the creation of value in several asset classes and sectors that we haven’t seen for many years.

Fixed income is likely to start recovering sooner than equities, but from where we’re looking today, a foundation for solid returns from both asset classes exists as we move on from a very difficult year.

We thank you for continuing to place your trust in us in managing your portfolio. Finally, from all of us in the investment team, Emma, Will, Becky, Kim, Hayley and me, we wish you a very happy New Year and hope 2023 brings health, happiness and joy to all your homes.

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The Bank of Japan surprised everyone with an announcement their policy of pinning the market interest rate on 10-year Japanese government bonds to a target of 0.25%, was being adjusted to allow those yields to drift higher to 0.5%. You could consider yourself justified in shrugging your shoulders and saying, “so what”, and you’d be largely right in doing so, were it not for the fact that the inactivity of the Bank of Japan over recent years, means that any movement demands an attempt to interpret the signal. In the real world there will be minimal impact (the Bank didn’t adjust anything else such as the policy rate for example), but the signal it sends, lends two possibilities.

• It buys breathing space allowing the Bank of Japan to continue its yield curve control (the name given to the policy of controlling the yield on its bonds) making it more sustainable over the long term. There are downsides, one is the amount of bonds the central bank has had to hoover up from the market to control the yield – by value, the Bank of Japan recently passed the point of holding over half of all Japanese government bonds.
• Alternatively, it sets the ground for a broader and more sweeping reassessment of these unconventional policy measures in advance of a change in the Bank of Japan Governor in April next year, easing the transition for a future Governor.

Only time will tell, but any change will lessen the downward pressure on the yen.

Improving Corporate Reform

During 2022, the Japanese stock market undertook a restructuring and governance reform into Prime, Standard and Growth sections, with Prime listed companies being the most sought after. The reforms seek to sustainably increase corporate value for shareholders, by ensuring better liquidity (and ignoring cross-shareholdings between companies in this calculation), more transparent and independent Boards and greater incorporation on ESG matters. Outside of these corporate reforms, other reforms, such as to encourage Japan’s hidden asset of highly educated women into the workplace are ongoing.

Value

Compared to the MSCI World Index, MSCI Japan has a higher dividend and lower valuation metrics than the global peer.

Conclusion

Japan inevitably has hurdles to overcome. Poor demographics, high levels of debt and traditional reluctance on encouraging women into the workplace and immigration to boost its economy hinder.

Tailwinds come from an improving corporate governance framework focused on unlocking Japan’s relatively attractive valuation and improving shareholder returns, coupled with a potential currency booster if the Bank of Japan adjusts policy.

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The table below shows Investment Association sector average returns broken down by asset class and geography, this time in sterling. The US dollar was strong in 2022 vs. sterling, yen and euro but there was a step change in Q4 ’22; sterling rallied from its lows post the Kwasi mini-budget, and the US dollar weakened against a broader mix of currencies.

Data from FE Analytics

Most asset classes enjoyed a reversal of fortunes in the final quarter of 2022. Index-Linked Gilts, North American equities and UK direct property, the latter two of which have enjoyed positive returns throughout 2022, fell to the bottom of the pile, while some of those asset classes that had been in the doldrums enjoyed a positive end to the quarter.

Europe excl. UK equities finished the quarter in low double-digit territory. In what has been a tumultuous year in general, Europe felt the impact of the war in Ukraine more sharply than other equity markets, due to not only its proximity but also Russian energy dependency. UK equities broadly benefitted during the quarter with high single-digit returns thanks to its high exposure to energy, resources and financial stocks.

Emerging markets, specifically those with proximity to China fared less well during the quarter as China rushed to transition from a zero-COVID policy to a ‘living with COVID’ policy. The murky Chinese property market is an added headwind for the region and akin to Europe, we anticipate a tough start to the year.

The following table shows the winners and losers in terms of the industrial sector for the quarter in local currency:

Data from FE Analytics

Old economy sectors, those that have not advanced significantly from a technology perspective, finished the quarter in poll position. It was a difficult year for most sectors but there was a notable improvement for all sectors during the quarter with energy, industrials and materials performing well. Sectors that had been the darlings over the last decade, technology and consumer discretionary (which hides within it names such as Tesla and Amazon), which have been hurt by consumers tightening their belts, were relegated to the bottom of the performance table.

There has been a notable style divergence throughout 2022, with ‘value’ as an investment style significantly outperforming ‘growth’ during the quarter and indeed, the year. Growth stocks have been particularly hard hit as a ‘growth’ company’s value today is based on its potential cash flows and profits in the future. When we believe interest rates will remain elevated in the future (as we currently do), the value of those future cash flows and profits become less valuable to us today. We refer to these assets as ‘long duration assets’ because their value is based on their long-term profitability. In short, rising interest rates are never a friend of growth stocks.

Fixed Income

It has been a difficult year for fixed income and index-linkers particularly, who finished the quarter in negative territory. Even short-dated fixed income, which usually provides downside protection, did not provide as much as we would usually expect. Pain was felt in the long-dated gilts which bore equity-like risk in 2022. Despite a difficult year, Q4 ’22 has seen a recovery in fixed income markets and defaults remain low.

We continue to use strategic bonds but have reduced short-dated fixed income funds and have tentatively started to increase duration; the fall in fixed income markets provided an opportunity to add to select pockets of value within fixed income.

Currencies

Whilst the story of the year was a strong US dollar, particularly against sterling, the story of the quarter was the dollar weakening, partly against an oversold sterling but also against a broader range of currencies.

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