A challenging year

Thus far 2022 has been a difficult year for investors, with most asset classes experiencing meaningful declines. Whilst this year’s setback comes after a number of strong years, it is no less challenging as a result.

Looking back at our view at the start of the year, we commented that we expected 2022 to be a ‘bumpier’ year and that there was the possibility that an inflation overshoot and a faster pace of interest rate increases could impact markets.

This view was informed by history, looking back at past interest rate cycles, noting that equity markets tend to struggle when interest rates are going up quickly.

In recognising the potential for a more difficult year, we also noted that equity market valuations looked reasonable to us and thus investors should continue to be compensated, for having to ‘endure’ periods of discomfort, with reasonable returns.

It is fair to say, however, that we did not envisage the severity of the decline across asset classes in the first half of the year. Whilst it was clear that central banks were going to increase the cost of money to attempt to quell inflation, we underestimated the pace of bond yield rises in the first half.

I think it is fair to say that we have seen an interest rate ‘shock’ this year. The debate around what has caused the persistency of higher inflation is still ongoing and there are multiple contributory factors, including the release of pent-up demand, ongoing supply chain challenges and rising commodity prices, as a result of the war in Ukraine.

For most of last year, central banks communicated their view that inflationary pressures would subside as the economy re-opened, but we have seen a sharp change in tone in recent months.

Although supply chain challenges seem to be improving, central banks essentially said we can’t wait any longer and have decided to slow the economy, via interest rate increases, in order to restore a demand/supply imbalance.

In the short term, this is a clear negative for asset prices. Fixed income or bond assets fall in value as bond yields increase, whilst equity valuations also fall in line with increasing discount rates and concerns over future economic growth.

Ordinarily, when interest rates start increasing it is because the economy is in good health and expanding, such that any impact from rising rates is offset by stronger earnings growth for companies.

The risk now is that the urgency to quell inflation results in a contracting economy, or recession, and earnings decline for a period.

The good news is that, thus far, we have seen earnings growth despite these challenges and, as a result, valuations for equity markets have come down very sharply. Indeed, valuations across markets look quite attractive by historic standards. For example, at the start of the year we noted that the forward earnings yield for the world equity market was c.5.5%; now it is c.7%.

For the first time in years, we can also see the prospect of ‘ok’ returns from fixed income assets too, with the US ten-year yield now 3%, even if this is clearly below prevailing inflation.

This very brief analysis shows us that forward returns have increased, and that we should look forward to a recovery from this year’s temporary setback and good returns over the long term.

The challenge in the shorter term for equity markets is around earnings. I think we need to be humble around economic forecasts, as most prove wrong, but it is clear that the economy will continue to slow, and the probability of a recession this year or next has increased materially.

This will clearly put pressure on corporate earnings, with cyclical sectors likely more vulnerable. Now, this has been at least partially priced in, with the US equity market experiencing a 23.5% decline since its high this year.

As ever, history is a useful guide for context. Notably, looking at declines for the US equity market during similar periods of monetary tightening and recession, we see an average decline of 22.4%. We have also seen greater than 20% market declines with no recession, with the most analogous period in the mid-1960s, when the US market experienced a c.22% decline.

However, we should also acknowledge that there have been deeper, more significant setbacks, including the global financial crisis, the aftermath of the tech bubble & 9-11 attacks, the oil crises of the mid-70s and the Covid pandemic, when on average the decline was well over 40%. Whilst we do not envisage a similar crisis today, it is still important to recognise these periods in the analysis and that the median decline for US markets during a recession is c.30%.

It is also worth noting that investor sentiment is very negative today, with surveys showing investors are as negative as they tend to get outside of major crises. This is usually a pretty good contrary indicator.

Putting this altogether, we have much improved valuations, a market decline that is at least partially discounting a recession and very negative investor sentiment. Historically, future returns have been quite high when we have had such a position, even if there is further downside in the short term.

Thinking about a more negative short-term outcome leads naturally to the question of robustness and resilience of portfolios. This is distinct from price performance, but more a question of the quality of the assets we hold in portfolios.

Higher quality equity assets haven’t proven especially helpful thus far in 2022, as valuations have fallen due to rising rates. However, if we do see a more challenging backdrop and a deeper recession, it is likely that companies that have enduring, structural growth and durability will outperform.

This is where our focus is today and, following the declines we have seen in the first half, we are seeing quite attractive value in some of our preferred equities, equity strategies and even fixed income funds.

For example, we see really high quality companies trading on free cash flow yields of 5-6%, we see investment trusts with proven investment managers trading on double digit discounts and we see well managed fixed income strategies yielding 4-6%.

Whilst the near term may remain challenging, we believe that building portfolios with high quality characteristics, at these valuations, will allow us to weather challenging times, whilst setting portfolios up for the eventual and inevitable recovery, as we look out longer term.

As always, please do not hesitate to contact us to discuss our views further.

Ian Quigley
T: +353 1 2600080
E: ian.quigley@brewin.ie

www.brewin.ie

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