Market Update – May 2022
Chris Brown, CIO, 19th May 2022
As the table above shows, it has been another tough quarter for global markets. Inflation is higher and looks to last longer than investors had previously thought. This means faster and higher interest rate rises for the next 12 months. Bonds, which normally offer some cushion to equity market falls, have lost money as these interest rate rises have been priced in. In many ways, this is a continuation from the first quarter where it was commodities and inflation linked assets like energy and mining equities and our own real asset investments (of which more below) that were the only real safe havens. The high weight of energy and mining stocks in the UK All-Share index is the main reason UK equities are the best performing major market year to date. To illustrate this, the more UK focussed FTSE 250 Index is -14.5% YTD, in line with other global equity markets.
On one level, these sorts of moves, whilst always unpleasant to go through, are also pretty normal. The US S&P 500 Index is now down -18% YTD. This sort of correction (defined as a fall of between – 10% to -20%) has happened 24 times since 1980. One year following the lows the market has been up 22 times for an average gain of 23%. This assumes, of course that we do not keep on falling into bear market territory (defined as a fall of -20% or more) as we did in 2000 and 2008. Here losses were larger and took years, not months to recover. These larger falls were also associated with deep recessions. Yet even in recession, there are opportunities to be found. As we saw most recently in the Covid pandemic, each crisis inevitably gives you opportunities to buy good assets at lower prices.
Where are the opportunities today? To answer this question, we think there are three main scenarios facing investors:
- Stagflation: inflation remains high, interest rates have to rise much faster than people think and economic growth rate slows.
- Slow down and recession: the peak for inflation is in and from here we will see falling growth and rising unemployment.
- Soft-landing: the interest rate rises that markets expect for the rest of the year along with the tightening implied by rising energy prices (and tax rates) are enough to slow the economy without tripping it into a (major) recession. Although we are always focussed on the risks that can happen to a portfolio, it is worth remembering that worst case scenarios do not often materialise. Equity markets habitually climb a wall of worry. You should know that the core part of your portfolio (which is generally pretty stable over time) should be well positioned to profit if more benign outcomes prove to be the case again.
That said, scenario 1, Stagflation, has been firmly in charge in 2022. The challenge we face as investors today is the sorts of assets that work well in scenario 2 (recession) are likely to be the opposite to the inflationary ones that have worked so well year-to-date. Commodities have been the strongest out-performer this year and have been behind much of the inflation we have seen. However, in a recession we would expect demand for commodities to fall. This means it is possible that we have already seen the highs for commodities this cycle. Similarly, fixed income has had the worst start to the year in recent history as rates have risen to combat inflation. However, as and when the economy slows, central banks will at some point be under pressure to cut rather than raise rates once again. This would mean that fixed income would become attractive again both as an outright investment but also as a diversification away from equities.
How are we dealing with these challenges at IPS? We think it is too balanced today to come down heavily either in the Stagflation or Recession camps in our portfolios. Instead, we are focussed on keeping our exposure to the right kind of inflation linked assets as well as adding some protection to our portfolios if a recession does indeed materialise. In practice this means we have/are implementing the following changes into our portfolios:
- Even though we think the top for commodities might well be in we still think energy stocks look attractive. The transition to renewable energy (of which more below) will inevitably be slow. In the meantime, poor capital allocation and environmental pressures have limited investment and growth in enhancing supply. Longer term energy prices look to us to be well supported and energy and mining companies look good longer-term investments. We are adding a little to our existing energy and mining exposure via our preferred global value funds.
- That said, we also need to get ready for a potential slowdown. We are seeing early signs of businesses cutting back especially in sectors (like technology) that have been hardest hit by the recent equity market falls. We have therefore reduced risk levels in our portfolios mainly by cutting our equity overweight’s.
- Our best performing assets this year have been our real asset investments. These are cashflow producing assets such as renewable energy producers, batteries and specialist property investments. They have the twin advantages of being defensive in nature as the cashflows do not depend much (or at all) on the business cycle but also offering partial inflation protection as the cashflows come with direct or indirect inflation linkage. They therefore look well placed for both scenarios 1 (Stagflation) and 2 (Recession).
Within this asset class, renewable energy looks to us to be particularly well placed. The focus for Europe on energy independence from Russia should keep energy prices high and so help returns for our existing solar and wind farm investments. The need for further growth in this area should also help returns for investments such as batteries which provide the infrastructure needed to support sources of energy which (like wind and the sun shining) are volatile in nature. We are therefore recycling the proceeds from our equity sales into these sorts of opportunities.
- Finally, a word on fixed income. This has been a very poor 12 months for fixed income investments. However, as prices fall so future returns (i.e. the yields the bonds pay) automatically rise. This means that, little by little, fixed income is becoming a more attractive hunting ground once again. It is also well placed to weather any recession. Fixed income might once again be an attractive source of returns for you for the next few years. If the slowdown continues we will be looking to add more at today’s higher yields.