2022 Q3 Market Commentary
Summary
▪ This has been the worst first 9 months of the year for traditional (i.e. equity and bond) portfolios since 1931. Rising interest rates and the risk of recession have pushed prices for both bonds and equities down.
▪ Interest rates have been rising to slow inflation. The key question is how far interest rates have to rise to get the job done and how big the resulting slowdown will be. The UK’s recent mini-budget did not help matters by pushing interest rates even higher in the short term.
▪ We cut our equity exposure and added to alternatives at the start of the year. Today, high quality bond portfolios are yielding over 6%. This looks like the best opportunity to us and we are adding to our investments in this area.
▪ The outlook for equities heading in to a recession is not good. That said, given today’s low valuations and investor positioning, equities could rise sharply once the worst is over. Whilst we are always mindful of the amount of risk we are running in our equity investments, we do not want to miss out on that opportunity.
As you can see from the numbers above, this has been a very difficult first 9 months of the year. We show the equity, bond and listed real estate returns for the main markets for Euro, US Dollar and Sterling investors. Alternative assets have provided some relief as we discuss below but not enough to offset the falls in equities and bonds. Even these have started to struggle under the pressure of higher interest rates globally. The one comfort for GBP and Euro investors has been the strength of the US dollar which has provided a cushion to the fall in the value of US assets. US investors, of course, have been on the other side of this and seen their international investments fall by even more because of dollar strength. All this has meant the worst start to the year for traditional (i.e. equity and bond) portfolios since 1931.
Whilst we have been through periods like this before (and expect to see them again) we know they are always painful to experience. That said, the longer-term investment opportunities look better today than they have in a long time, in part because the era of zero interest rates looks to be finally over. The transition from zero interest rates has, however, triggered many of the losses we have seen this year. This has been a year of dramatic change. If, therefore, there is anything you want to discuss in more detail, please do get in touch.
Unusually, it is the UK and the UK government that have been at the centre of events in the last few weeks. The Kwasi Kwarteng mini-budget increased borrowing by the government by £160bn over the next 5 years. How is this going to be funded? The answer is interest rates need to rise to attract new UK gilt investors and we saw some dramatic moves shortly after the budget announcement. As an example, the interest rate on 30-year UK government bonds rose from 3.8% the day before the mini budget to 5% 3 days later. These higher rates, like gravity, push other asset valuations down. If you can earn 5% on UK government debt, many of today’s property yields (for example) suddenly look a lot less attractive. Much of the fall in liquid real estate markets you can see in Table 1 reflects this new reality.
The market reaction to the mini-budget led to one of the main measures (highest rate income tax cuts) being pulled. The Bank of England has also been forced to intervene to stabilise the gilt market. We shall see how many more changes to the initial mini-budget are on the way. For now, however, the impact of higher interest rates remains. The average 2 year fixed mortgage rate in the UK currently stands at 6%. This combined with higher house prices means that mortgage affordability is back to levels last seen in the late 80s/early 90s (see Chart 1). This points to tough times ahead for the UK housing market and, by extension, the UK economy.
As these risks rose in the first half of the year we cut our equity exposure and re-allocated this to alternatives. We also cut our interest rate exposure to the minimum we thought prudent for diversified investment portfolios. Since then the economic outlook for the UK has worsened and the interest rates on higher quality UK debt have risen to over 6%. The temptation therefore is to reduce our equity holdings further. However, as we discuss below, valuations in many markets, including the UK, look cheap today. Also, as and when inflation starts to fall and rates peak for this cycle, equities could rally sharply (as they often do after difficult bear markets). Economists (who, we would caution, have generally been too optimistic for the past 12 months) now think the peak is more or less here for US headline inflation, and should start to fall in the UK and Europe in the first half of 2023 (see Chart 2). We want to make sure we capture the rally when it comes. This is limiting our desire to be too defensive.
Given this economic backdrop, here is an overview of the valuations and opportunities we see in the various markets we invest in. As usual, we split our discussion into our three broad investment sectors: equities, bonds and alternatives.
Equities 
Company profits have been relatively strong in 2022. The 25% or so falls we have seen in many equity markets have come from the multiples you pay for those profits going down (so effectively equities are cheaper to buy). This has, of course, created some interesting looking opportunities. US equities are now trading in line with their 30-year averages, European equities look cheap and UK equities look very cheap. Chart 3 shows UK equities are currently trading at 8.9x next year’s expected earnings. This is in line with the lows we saw in 2011. We bottomed at below just 8x in 2008. Needless to say, both these lows proved to be great longer-term buying opportunities (in spite of and, in reality, because of the doom and gloom surrounding the markets at the time).
There is plenty of doom and gloom today! Unfortunately, valuations are an almost useless predictor of shorter term (less than 12 month) returns. If we are right about a UK recession then it is hard to see a meaningful rally in equities in the short term as today’s earnings estimates are likely to be too high. We cut equities in Q1 as the economic outlook worsened. The price you pay is, however, a decent predictor of longer term- returns (say 3 years or longer). Today’s valuations for some markets like the UK look historically cheap. We have therefore been reluctant to cut our equity allocations further in spite of the outlook. That said, some of the opportunities we see in the fixed income markets are now looking attractive following the sell-off.
Fixed Income
House buyers’ mortgage interest problem is investors’ bond buying opportunity. As we discuss above, the UK looks to have a sweet spot of higher yields (above 6% for many assets) and a deteriorating economic environment (so limited risk of yields going much higher). For our UK clients, we have reallocated some of our cash to this opportunity. Table 2 shows current yields compared to the market expectation for the average inflation rate over the next 5 years. These are 3% compared to today’s CPI headline rate of 9.9% reflecting the expectation that a recession will slow inflation sharply next year. This means attractive inflation plus 3% or so forward looking expected returns. We see similar attractions at the front end of the US and Euro bond markets.
Yields on higher risk markets like US high yield and emerging markets are now above 9%, which has also historically been a good entry point. However, this yield comes with the risk that companies default and do not pay you back. You therefore need to lower these returns to allow for these expected losses. When you adjust for this, the returns are respectable relative to the opportunities we see in equities and higher quality debt without being especially attractive. We are maintaining our small allocations to these markets but are not looking to add.
Alternatives
Our alternative investments consist mainly of cashflow producing assets that are listed as trusts on the UK stock market. The cashflows these assets produce are designed to be stable, pretty much independent of the business cycle and have inflation linkage. Even after the many dramas we have seen in the last few weeks this story remains very much intact. To illustrate this here is a high-level overview of the main sectors we invest in:
• Renewable Energy: This includes solar and wind farms, the batteries needed to make them effective for the national grid, and other green energy investments. Clearly, energy independence from Russia is here to stay. Even though cheap Russian gas is rapidly being substituted from other sources, energy prices will stay high and this provides a tailwind for the sector. 6%-7% returns seemed very achievable at the start of 2022. In spite of a likely government cap on the energy prices received by these renewable generators, these investments still look attractive.
• General Infrastructure: Here we have hospitals, schools and other infrastructure projects provided by the private sector to governments, typically with long-dated, inflation linked contracts. We also have investments in more modern infrastructure in areas such as (energy efficient) data centres and undersea high-speed data cables. Again, the underlying investment opportunity is unchanged from 12 months ago and the inflation linkage of these cashflows have meant they have been able to keep growing.
• Specialist Property: the impact of higher borrowing rates will naturally bring down broader property prices. Our assets are, however, specialist properties such as care homes and social care housing. Cashflows again have inflation linkage and these should prove to be robust and independent of the broader business cycle.
Our portfolio of alternative assets sold off following the turmoil triggered by Liz Truss’s initial budget proposals. This has impacted, of course, this quarter’s portfolio returns. However, the longer-term investment opportunities we see here still look very attractive to us. One area we are watching, though, is the impact of higher borrowing costs for these investments. Our investments are therefore centred on assets with very low leverage or where borrowing costs were locked in at lower rates for the next few years.
Putting this all together, we are rotating our portfolios into some of the attractive returns bond markets are offering (and it has been a long time since we have been able to write a sentence like that).
One saying in markets is the worse you feel about the short term returns the better you should feel about longer-term ones. This was certainly true in 2008 and 2011 (the last time we saw UK equity markets at today’s levels). We are confident that it is also true today. Whatever the future holds, we will continue to communicate regularly with you. And if you have any questions or need more depth on any of this or your portfolios, please do get in touch.
Chris Brown
Chief Investment Officer