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Investment Update – Winter 2023

2022 was a difficult year for most investments, but unusually, in a tough year for stock markets, it was Cautious investors who experienced the worst of the downturn. Rapidly rising inflation, caused by supply chain disruptions and low unemployment, left central bankers no choice but to react at similar pace with interest rate rises. This was bad news for bonds and fixed interest investments which are most sensitive to changes in interest rates.

There was some respite in the final quarter, with a feeling that recession was now priced into markets. Riskier assets/equities certainly bounced as inflation peaked, helped by falling oil & gas prices since the summer. A mild winter and expectations that interest rate rises would slow, or soon pause, also buoyed buyers. Small companies and European equities were big beneficiaries in the fourth quarter, the latter as a result of falling energy prices. China also rebounded strongly after a dismal 2022, with their zero-covid policy very much determining sentiment. Now one can only hope that they have moved beyond this stance.  Value stocks, particular in the energy sector, topped the performance tables over the year with the Russia/Ukraine conflict pushing prices higher.

Fundamentally Sound

For several years, KMD has been positive on value stocks due to their fundamentals and inflation protection qualities. While technology stocks/growth equity won the race in 2020, the order has very much changed over the past two years where a ‘value’ tilt in our strategies helped contain losses in what was a very painful year for many. We have, for some time, been positioned for higher inflation and, while no diversified portfolio can completely protect against inflation shocks, we faired very well in ‘21 and ‘22. KMD’s strategies focussed on short maturity bonds, with lower interest rate risk which has also helped contain downside risks. Growth stocks bore the brunt of last year’s interest rate rises  and were down 29% compared with losses of just 6% from value stocks.

It is pleasing to see fundamentals finally working their way into share prices.

The future is not without its challenges, however ‘deep’ or ‘shallow’ the  recession we are facing. Supply chains are yet to right themselves entirely and deglobalisation is well underway, leading us to believe higher interest rates will be sticky. We think markets are a little optimistic by pricing in rate cuts just one year away, given inflation may  still be above trend ie above 2%. Prices will rise much more slowly this year, but one can’t help but think central banks are going to be much more cautious in lowering interest rates. This is relevant since all eyes remain on the Federal Reserve (and US rate policy) and it is rate expectations which will continue to dictate where equity markets go from here (as has been the case for some time).

Improving Value

On the positive side for 2023, equity valuations are more realistic than they were at the beginning of last year and energy input prices (oil & gas) are coming under control. A similar downside to that seen in 2022 is therefore less likely. In terms of home ownership, when compared to the past, today, not only is there a much higher proportion of homeowners with fixed rate mortgages (especially in the US)  who have not  yet been impacted by rising rates, but homeowners are also not as indebted as they were in the 2007/8 crisis.

Markets tend to price risk very well, but we could see a couple of positive ‘surprises‘. Firstly, de-escalation between China and the US in relation to Taiwan and agreement to cease their trade war would certainly boost markets. Similarly, if continued unnecessary loss of life fuelled a Russian revolt and Putin were to be overthrown, we could see an end to the conflict and re-opening of food and energy supply lines. Either outcome would provide a boost to stock markets.  However, for now, they are just potential ‘surprises’ and unfortunately, both carry even greater risks if they escalate instead, so positioning for either outcome with high conviction is unwise.

We have been cautious for some time and while, importantly, stock markets are now better value, so too are defensive assets, cash and fixed interest. Therefore, we see limited logic in now taking considerably more risk than we have done over the past decade. For the first time in a long while we are becoming excited about the prospects for Cautious investors and fixed interest.

Another tough year ahead

On the side of caution, housing market weakness has already begun with further falls in prices and construction activity likely, although price drops should be contained only by limited stock. Continued strike action in the UK remains disruptive to productivity and if the government concedes, could spark inflationary pressures through higher wages thus forcing interest rates higher. Even without wage increases, UK government debt issuance is set to soar over the next decade, with Citigroup forecasting this at c.£240bn a year compared to just a third of that (c.£80bn) over the past decade. With interest rates also over three times higher than they were, that is a 10-fold increase in new debt servicing costs! No wonder then that governments are not entertaining union demands.

High corporate debt levels, rising wages and extended profit margins lead us to believe earnings forecasts, that make up today’s more attractive valuations, may have undue optimism built-in. Equally, bond markets appear to be calling central bankers’ bluff in that interest rates will fall sooner (by the end of the year) than central banks are indicating. Markets often know best, but this time round we are with the central banks ie anticipating they will want to see inflation fall to target and remain there before considering a reduction in rates.

The worst of the inflation and market correction is probably behind us, but another economically challenging year lies ahead. In our view, the current economic balance is not conducive to high levels of conviction across most assets and regions. There are some areas where profit taking could be wise. For example, in energy stocks with additions to oversold sectors such as REITs or even bonds. US and Growth stocks could enjoy a little rebound, but our medium to long-term view remains that value stocks and emerging markets are likely to offer better value amongst risk assets with the potential for smaller companies to be added at opportune times.

Finally, cautious investors who suffered most in 2022 will be pleased to hear we are quite optimistic  about the outlook for those who are more risk averse (particularly in risk adjusted terms). The ‘return gap’ between high-risk and low-risk portfolios is likely to be much smaller in future and high-risk investors should carefully consider if additional risks will be commensurate with diminishing excess returns.

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.

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