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.
Brewin Dolphin Wealth Management Limited trading as Brewin Dolphin and Brewin Dolphin Ireland, is regulated by the Central Bank of Ireland.
For UK-based clients only: Brewin Dolphin Ireland is deemed authorised and regulated by the Financial Conduct Authority. The nature and extent of consumer protections may differ from those for firms based in the UK. Details of the Financial Services Contracts Regime, which allows EEA-based firms to operate in the UK for a limited period to carry on activities which are necessary for the performance of pre-existing contracts, are available on the Financial Conduct Authority’s website. Registered Office: 3 Richview Office Park, Clonskeagh, Dublin 14. Registered in Dublin, Ireland No. 235126
This publication should be regarded as being for information only and should not be considered as an offer or solicitation to sell, buy or subscribe to any financial instruments, securities or any derivative instrument, or any other rights pertaining thereto (together, ‘investments’). This publication is classified as a ‘marketing communication’ in accordance with the European Union (Markets in Financial Instruments) Regulations 2017. This means that (a) it has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and (b) it is not subject to any prohibition on dealing ahead of the dissemination of investment research. Brewin Dolphin does not express any opinion as to the present or future value or price of any investments referred to in this publication. This publication may not be reproduced without the consent of Brewin Dolphin.
The information contained in this publication has been compiled from sources believed to be reliable, but, neither Brewin Dolphin, nor any of its directors, officers, or employees accept liability for any loss arising from the use hereof or makes any representations as to its accuracy and completeness. The information contained in this publication is valid as at the date of this publication. This information is subject to change without notice, its accuracy is not guaranteed, it may be incomplete or condensed and it may not contain all material information concerning the matters discussed herein.
This publication does not constitute investment advice and has been prepared without regard to individual financial circumstances, objectives or particular needs of recipients. Readers should seek their own financial, tax, legal, regulatory and other advice regarding the appropriateness or otherwise of investing in any investments or pursuing any investment strategies.
An investment in any of the investments discussed in this publication may result in some or all of the money invested being lost. Past performance is not a reliable guide to future performance. To the extent that this publication is deemed to contain any forecasts as to the performance of any investments, the reader is warned that forecasts are not a reliable indicator of future performance. The value of any investments can fall as well as rise. Foreign currency denominated investments are subject to fluctuations in exchange rates that may have a positive or adverse effect on the value, price or income of such investments. Certain transactions, including those involving futures, options and other derivative instruments, can give rise to substantial risk and are not suitable for all investors.
Brewin Dolphin (or its directors, officers or employees) may to the extent permitted by law, own or have a position in the investments (including derivative instruments or any other rights pertaining thereto) of any issuer or related company referred to herein, and may add to or dispose of any such position or may make a market or act as a principal in any transaction in such investments or financial transactions.
Brewin Dolphin’s conflicts of interest policy is available at www.brewin.ie/conflicts-policy-summary