Investment Update – Winter 2022
Those with a keen interest in financial markets will have noticed that 2022 has brought with it the brewing of a dramatic storm in the more ‘glamorous’ areas of the stock market.
The US S&P 500 index is down 8.1% year-to-date (at 27th Jan), while the ‘go-faster’ Tech-biased Nasdaq is down even more at 13.7%.
The high Growth style of investing, epitomised by the story of technology companies “changing the way we live our lives”, has faced relentless selling pressure. This has driven down American stock markets, due to the disproportionately large weightings that these areas represent within US bourses. The same dynamics are also playing out globally, simultaneously affecting other major regional stock indices.
If you are not a close follower of financial markets or only follow the UK’s FTSE 100 index, you might be surprised to learn of this mini drama. This is because the FTSE is up 2.3% over the same time period.
To understand why some investment areas are currently feeling acute pain while others are coming out seemingly unscathed, it is necessary to revisit the polarised dynamics that have characterised the investment world of the past few years.
Financial markets have effectively been playing out the financial equivalent of the ‘tortoise and the hare’ story, much to the frustration of any ‘fundamentally’ focussed investor. In the financial version, the Tech and other disrupter high-flyers (trading at very high valuations) continued to soar (despite eye watering price tags) while more traditional investment types (trading at sensible valuations) remained grounded. Most recently – in effect since the first vaccine discovery in November 2020 – this tide has started to turn, becoming more violent since the start of 2022.
It is important to point out that we are not against inevitable change when managing your investment portfolios. Instead, our greatest concern was always that such popular areas of the marketplace had become excessively overbought, leading to – by historical standards – very high valuations. If the past serves as a good guide, such stories never tend to end well. The only debate is usually for how long and by how much the bubble might inflate before it inevitably pops. For this reason, we chose not to back the seemingly unstoppable ‘hare’ based on a long-term understanding of financial market human behavioural dynamics. We prefer to remain disciplined to the long-term fundamental rules of the game as we see them.
Although markets never move in a straight line, it seems that a turning point may now have been reached. This is due mainly to higher inflation expectations, as market participants came round to believe inflation might actually be less temporary than first thought. As a result, more powerful expectations of interest rate hikes in the US (and globally, with the Bank of England recently hiking rates by 0.25%) have provided the catalyst for change, upsetting what to us always looked like a fragile set-up.
The first vaccine announcement in November 2020 served as a good marker of when the tide started to turn. It acted as an economic recovery catalyst and the change has been slow and gradual but turning more violent of late.
The investment types starting to come back into vogue include cheaply priced Value stocks, including UK Equities and generally most developed market stock markets, aside from the expensive headline US market (due to its large Tech weighting). Property, Commodities, defensive stocks – including Infrastructure – have also benefitted from this rotation. It might not come as much of a surprise to learn that these investment types are all generally perceived as inflation beneficiaries (or of rising interest rates in the case of Financial stocks, a Value sector), which makes sense given the sudden reassessment of this risk factor.
Fast Growth, Tech and higher risk Mid and Smaller Cap Equities have lagged. Their valuations are often based upon more distant growth prospects materialising (never guaranteed), which mathematically benefits from lower interest rate expectations or hurts when rates are rising. This is based on the fundamental way in which companies are always priced relative to risk-free returns ie interest earned on cash savings.
Interestingly, we note that High Yield bonds (the debt of low quality, financially less secure companies) has not really been affected by the recent turbulence. To us, this suggests the rotation between investment types does not look to be a function of weaker economic growth prospects. Rather, inflationary pressures are arguably more a function of continued economic progress, as well as other one-off factors such as older workers choosing early retirement thereby reducing the supply of available workers, leading to wage increases, which feeds into inflation. Again, this too makes sense from the perspective that cheaply valued, cyclical areas of the market may stand to gain.
Turning to other asset classes, not surprisingly, Inflation Linked bonds have outperformed conventional Bonds over the past year. Gold has edged up very slightly over the past three months, but has generally offered dull performance due to its defensive properties at a time of escape velocity since the initial Covid shock.
After a disappointing 2021 (Large Cap Tech & China faced pressure earlier than others for their own China-specific reasons), Emerging Markets have held up well during 2022. Unsurprisingly, Japan, being a large importer of energy during a period of soaring prices, has struggled. However, Japanese stocks appear to offer reasonable value looking ahead. The FTSE 100 is firmly on the performance global leader board over the past 12 months, albeit there is still significant ground to make up on a multi-year view.
Summarising, investing is very much about patience and not getting carried away with greed and fear. We are encouraged that value strategies are making back much of the lost ground in the ‘hare’ era. Importantly, the investments we hold on your behalf are not giving us sleepless nights during what might be proving to be a more stressful time for many.
The details, views and opinions expressed above are KMD’s, can change at any time and are not intended to be advice or a solicitation to make an investment. Professional advice should be sought before acting on any information contained in this document. The value of investments can fall as well as rise and your capital is not guaranteed. Past performance is not a reliable indicator of future performance.