Hope springs eternal…
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.
