Q4 2022

By Alex Scott | 11 January 2023

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Market Update

Bond interest?

Q4 in summary:

  • 2022: the inflation-driven bear market for stocks and bonds
  • Q4: another bear-market rally?
  • Leadership changes: Value beat Growth, Europe beat the US for the year, China beat the US for Q4
  • No protection from bonds: the worst year on record?
  • Sterling weakness: UK equities are not as strong as they looked!
  • Recession incoming, inflation rolling over, central banks waiting to make sure?
  • How bad is the outlook - and what is priced in already?
  • The cycle vs the long-term: shifts in bond markets and implications for strategic portfolio constructions

Investors will be relieved to see the back of 2022. This was a year of treacherous conditions and strong headwinds. Markets were forced to price in shockingly high inflation, rapidly rising interest rates, an end to years of central bank Quantitative Easing, and a rocky outlook for economic growth.

Global equities ended the year down 18%, with US large-cap growth stocks - the technology-heavy worldbeaters of the previous five years - falling around 30%. Value stocks and European equities fared a little better, showing more modest losses. Only Energy stocks (for the second year in a row) made significant gains.

In the face of the biggest inflation shock in at least thirty years, central banks took a much more aggressive stance than markets had expected, pushing interest rates rapidly higher and forcing a dramatic repricing of bond markets. Annual returns for core government bonds in the US and UK were the worst seen in at least two centuries: US Treasuries fell 12% (longer-maturity of 20yrs+ falling over 30%). Gilts fell 25% (much worse than in any year of the 1970s inflation shock episode). So government bonds gave no protection for investors seeking security. There were also sharply negative returns from riskier fixed-income sectors (corporate credit, high yield “junk bonds”, emerging markets) and inflation-linked bonds. This meant that most investor efforts to find shelter in diversification came to nothing.

Stock markets falling in a calendar year is not unusual; investors understand that this is part and parcel of equity risk, the corollary of higher returns over longer periods. Bonds generating losses over a year is rare, but it happens from time to time (although hardly ever in double digits). But global bonds and global equities falling together AND by so much in so short a time, is essentially unprecedented.  

And yet, it could have been much worse: the final quarter took the edge off the pain for many investors. We had noted at the end of September that the conditions were building for a bounce, as investor sentiment had become extremely negative and some inflation indicators starting to moderate, and so it turned out: commodities and bond markets stabilised in Q4, riskier bonds rallied and global stocks rebounded 10% in the quarter, with global Value stocks in sectors like Energy, Industrials and Financials and beaten-up Asian equities leading the way. Chinese stocks in particular performed well in Q4, with optimism over a surprising U-turn in COVID policies late in the quarter, helping them to a gain of 12%, but they were still among the weakest markets for the year as a whole.

UK gilt markets endured a difficult year, with conventional gilts returning -25% and inflation-linked gilts losing over 30% of their value. In part, this was driven by a more acute inflation problem domestically and consequently higher interest rates, but it also reflected a loss of confidence in the stewardship of UK public finances in a year of political uncertainty, with investors demanding a bigger risk premium for lending to the UK government. This reached its climax with a brief period of intense volatility in the dying days of the short-lived Truss-Kwarteng partnership in Downing Street.

Although shares in small and mid-sized UK companies struggled, on the face of it, large-cap UK equities fared much better for the year, with the broad equity index essentially flat - in Sterling terms. There, unfortunately, lies most of the explanation: Sterling fell by over 10% against the Dollar in the year (despite a late, partial rally). So although global investors in UK equities benefited from the local market’s structural sector overweight in Energy and its almost total lack of exposure to large high-tech companies, they lost out from significant currency weakness. Indeed, for the first nine months of the year, as the Pound fell from US$1.35 to US$1.06 (and headlines screamed that Sterling-Dollar parity was inevitable), exposure to assets - any assets! - in foreign currency was a significant benefit for Sterling-based investors. That benefit faded in the fourth quarter, with the Pound rallying quite sharply (at least against the Dollar) after a change of Chancellor and then Prime Minister.

Investors are wondering when the pain will end. Are the bear-market lows already in place, or was the late 2022 rally another short-term rebound, with further losses ahead? Much depends on how sharp the economic slowdown turns out to be, and how much of this is already priced in: those are questions worth examining, but not ones that investors can answer easily with a high degree of confidence. Perhaps more important for long-term investors are questions that look beyond the ups and downs of the shorter-term economic cycle: how much has the investment landscape changed after 2022, and what does that mean for portfolio construction?

Economists’ consensus expectations, surveys of companies and households, and financial market indicators (such as inverted yield curves) all indicate at best a very subdued economic outlook with risks to the downside. Growth will be much slower in 2023 than 2022, with a recession seemingly baked-in for the UK and much of Europe, and quite likely in the US - perhaps not a racing certainty, with the consumer still drawing some support from a strong jobs market, rising wages and accumulated savings, but it is questionable how much longer these props can hold up in the face of ever-tighter central bank policy and the ongoing squeeze on living costs. Business confidence is falling and firms expect to cut capital expenditure - cuts to employment may follow. The higher cost of living, energy prices and mortgage rates are a lethal combination for households, and consumer confidence has collapsed. Sales of homes in the US and UK have already been hit hard, and lead indicators suggest price weakness ahead. Banks are tightening lending standards and credit is becoming harder to access and more expensive for both companies and individuals. The pathway to slower growth (or indeed to recession) is clear and this is reflected in the market consensus – it would appear that every outlook report, every strategy commentary, every survey of institutional or individual investors, and every economic forecast points to a slowdown in 2023. It is reflected too, at least to some extent, in financial markets: credit spreads have blown out to price in a higher level of defaults, stocks trade on cheaper valuation ratings than for years, and analysts have started to reduce profit forecasts, and yet many commentators expect that earnings forecasts are still too high and will fall further.

Investors know that a downturn is coming, and markets have moved somewhat to price that in. But the question of how bad that downturn will be, and therefore how fully it is now priced in, is tied to central bank policy - and that, in turn, depends on inflation.

In the face of clear evidence that a downturn is coming, central banks are still raising interest rates and running down their QE bond portfolios. Markets are unsure how much further the tightening process will go - the roadmap of the last thirty years or so, and particularly the post-2008 period, seems useless in a world where central banks are deeply worried about too much inflation - after a decade of worrying about too little of it. If central banks, led by the Federal Reserve, do indeed keep raising rates into a downturn and then keep rates higher for longer - as they keep saying they will - then it seems inescapable that the downturn will be deeper and more painful than markets are currently pricing in. And rapid rate cuts would unlikely come to kickstart demand and energise a new cycle as central banks want to be sure that inflation is subdued before releasing the brakes. The Fed has reiterated that it expects to continue raising rates this year and does not expect a first rate cut until 2024, but the market is pricing in a lower peak in rates being reached by mid-2023 and a policy “pivot” with the first rate cuts towards the end of this year.

This mismatch between the central bank and markets could be a key source of volatility in the coming months. The experience of past cycles shows that bear markets tend to bottom and start rebounding well before the trough in the underlying economy: investors look ahead to the future and price up financial assets for the real-economy recovery they can see ahead - often supported by central bank action, with a switch in tone from restrictive to supportive policy helping justify market optimism. If central bank support through the downturn is slower to arrive, or more limited in scale, than the markets currently hope, volatility would be significant. Inflation is key to how this will play out.

Economists expect inflation around the world to be peaking this quarter, or to have peaked already in some cases, with lead indicators suggesting it will moderate through 2023. Already there is outright deflation in some key components that contributed heavily to the inflation spike over the last 18 months or so, and surveys suggest that firms are having a tough time increasing prices across a broad range of goods and services. But there is a long way to go, with recent inflation readings still at extraordinary levels on both sides of the Atlantic: CPI at 7.1% in the US (down from a peak of 9.1% in June) and 10.7% in the UK (Nov data). Consensus expects inflation still to be well above central bank targets at the end of 2023.

Perhaps inflation will indeed fall fast enough to allow central banks the flexibility to ease off on the tight monetary policy a bit sooner so that growth to recover; the best possible result for equity bulls. Or perhaps the downturn will be sharp and deep enough to put intense political pressure on central banks to ease off sooner than they would like to, pushing us into higher inflation for longer instead of higher rates for longer; likely a much worse outcome for stocks. But somewhere in between there is the risk that markets will have to recalibrate their expectations and go further than they have already done to price in a more restrictive, less growth-oriented central bank in the face of a modest downturn.

Long-term investors should look through and beyond economic cycles: cycles come and go, growth and inflation rise and fall, and liquidity ebbs and flows. A clear eye on the long-term perspective can help investors look through short-term market volatility and protect them from the risks of over-trading and mistimed, emotionally-driven changes in investment strategy. Expectations for the year ahead may span a range, but most point to a slowdown or recession on some scale, corporate earnings under pressure, inflation falling and central banks slowing the pace of rate hikes. Strategists and investors wonder about the scope for positive surprises - a resolution of conflict in Ukraine? The complete re-opening of China?- and as usual speculate about possible downside shocks: rising geo-political tensions, a double spike in inflation, new COVID variants. 

But it is far more important for long-term investors to recognise the dramatic change in the investment landscape compared to a year ago, and what this can mean for portfolio construction for the decade ahead. Equity valuations have fallen: they may not be particularly attractive if cyclical earnings expectations continue to fall into the coming slowdown, but valuations for global equities as a whole are now a little cheaper than their long-term average. Valuation is not a great predictor of short-term returns, but can be far more powerful as a predictor of long-term returns: equity valuations today stand at levels where subsequent 12 month returns have tended to be positive more often than not, but more importantly, they are at levels where subsequent ten-year returns have always been positive.

The repricing of bond markets in 2022 - to the highest yields since the wake of the financial crisis - has even bigger implications for long-term investment strategy. Bond yields now present a range of opportunities: investors are paid to be patient and wait for opportunities, with yields of 2-3% in cash or short-term bonds; they are paid to diversify, with yields of 3-4% in government bonds and scope for meaningful capital gains from falling yields in a slowdown; they are paid to take inflation protection, with inflation-linked government bonds now offering a small positive real yield; and they are paid to take risk, with a wealth of options in riskier bonds across the spectrum, from investment grade credit on yields around 5% to junk bonds yielding 8% or more - and a host of more esoteric opportunities. These yields may still be below current inflation, but for investors who believe that inflation will not be sustained at current levels through 2023 into 2024, the opportunity to deploy capital in bonds is more interesting than it has been for years. The usable toolkit for multi-asset investors has dramatically expanded.

The repricing of bonds matters for other asset classes too: how much upside should investors demand from their equities (or their property, infrastructure or other alternative investments) to justify investing there rather than in government bonds yielding 3 or 4%? Can allocations to government bonds make an equity portfolio more robust and allow more risk-taking elsewhere outside the investment portfolio? Will earnings growth recover fast enough, or are equities already cheap enough to be a better investment than high-quality corporate bonds yielding 5 or 6%? Markets may have some way to go to fully digest the shift in bond yields and its various implications - but the fact that now these are even questions worth asking is an enormous and interesting change.

N.b. All content is based on data at the time of writing on 9 January 2023.