We are now six months into what is proving to be a very difficult year for investors with a range of factors having a negative impact on investment markets. In this newsletter I’ve looked to provide a general market overview together with some commentary on the main issues impacting markets.
The challenge for all investors is that we have almost no certainty regarding how positive returns will be distributed over time. This means that investors often experience short-term or even relatively long periods of negative returns.
Looking at, for example, a typical balanced portfolio (the IA Mixed 40-85 Sector is the right proxy for this) made up mostly of shares over 20 years, it failed to deliver a positive return in 2002, 2008, 2011 and 2018.
The most severe market falls were in 2002 (-18.14%) and 2008 (-21.47%).
However, looking at this over the long term, it has delivered annualised average returns of 6.49% over 20 years, despite suffering some years of severe market falls. This return is comfortably ahead of annualised average inflation of 2.08%, and also ahead of annualised cash returns of 1.154% (IA Standard Money Market) over same time period average of 20 years.
This is the reason for the investment truism that ‘time in the market is what matters and not attempting to time market entry’. This is why most people need to invest their medium to long term funds into portfolios of “real” assets – a mix of bonds, stocks, shares and other assets.
None of this reasoning really makes the experience of seeing your savings fall rapidly in value any easier to bear and investors are currently suffering a period of significantly increased market stress.
Over the first half of the year:
In brief, the main factors adding to these stresses are:
Conflict
Firstly, there is the terrible conflict between Russia and Ukraine which is hitting global food supplies as well as supplies of raw materials. The figures vary considerably but according to a recent FT report these two countries account for somewhere between 40-50% of the supply in major crops such as: sunflower oil, barley, maize and wheat.
The conflict contributes to inflation, causing central banks to raise interest rates. It also pushes up the cost of materials for companies, depressing profits.
Rising interest rates are particularly bad news for “growth” companies, especially if the full extent of the rate rises is unclear. At the moment, it’s not clear how high interest rates will need to be to tame inflation, with the UK, Eurozone and the US all recording high levels of inflation.
However, in the US there is some evidence that a demand slowdown is happening with the US Bureau of Economic Analysis showing a very sharp fall in expenditure over the past 3 months.
Interest Rates
Central banks (Bank of England, US Federal Reserve, European Central Bank) are moving to cool the economy by raising interest rates. The US Federal Reserve and the UK’s Bank of England Monetary Policy Committee (MPC) have lifted interest rates considerably from a very low base.
Covid19
In some parts of the world, we are still suffering from a hangover from Covid19. In particular, China has adopted a zero Covid policy leading to repeated lockdowns. For example, recent measures taken by the Chinese state to control the Omicron variant have impacted supply chains with effects felt globally.
Effect on your investments
All these factors contribute to risk aversion in financial markets. Investors move from equities into less volatile assets and this in turn depresses stock market valuations. Indeed, even some “haven” assets (e.g. Government Bonds) have struggled.
As a result, many of our portfolios are now showing negative one-year returns. In fact, one of the few asset classes to outperform this year has been installed renewable energy capacity.
We follow a fund run by the UK-based fund management company Gravis which buys into the generation, supply and maintenance of renewable energy. They’ve had a
strong year despite the risk of a windfall tax on profits made by energy generators, which negatively impacted the performance of some of their UK energy assets. Over six months this fund is up by more than 10%.
It is expected that increasing interest rates will dent consumer spending power and help cool the economy; this leads to lower profits and less consumer activity, which we call a “headwind” for stocks and shares.
However, with inflation so high, investors holding cash are guaranteeing a loss which means that in the medium-term investors are likely to move back into equities. As confidence returns, investors tend to move back to higher-risk assets in search of a positive return on capital.
In many ways, what is being described here is the economic cycle as the economy goes through periods of expansion and then contraction. However, this normal cycle is being exacerbated by several extreme factors.
There has been a marked shift from growth companies into what are known as value stocks which focus on dividend payouts or income yield. This is a shift from businesses with longer-term growth objectives into more short-term companies. Much of this selling has been undifferentiated with successful, growing businesses suffering sharp share price declines.
Our investment approach is based on keeping down overall costs, using tracker funds when appropriate, and using active managers where they operate in a specialist market area, such as thematic sustainability. Our managers tend to focus on high-quality businesses with solid growth prospects addressing readily identifiable social or environmental needs, such as: the need for cheaper energy, efficient product design or water infrastructure.
In our most recent client reviews, we’ve focused on tax planning opportunities (such as ISAs, pension payments and utilising capital gains tax allowances) as well as rebalancing portfolios in line with individual attitudes to risk and long-term objectives.
Over the past three months, we’ve also met with investment managers from WHEB, AEGON, Quilter Climate Assets and Liontrust (together these managers are responsible for around £20bn in invested capital) to discuss the performance of their portfolio companies. In these meetings we obtain as much information as we can on the fund managers’ overall strategy to try to understand their approach to managing risk. The focus has been on the fundamentals of company valuations: forecast earnings, cash flow and a better understanding of the markets for portfolio companies’ products and services.
We are currently working through our programme of annual reviews with clients and also booking in calls and meetings to discuss portfolios and performance. Please do get in touch if you would like to book a call.