Reflections

January is often a time for reflection and after a particularly challenging year for investors, now seems an appropriate time to look back over the past year and ask what we should expect in the coming years.

I’ll start by reviewing our first commentary of 2022, when we expressed a degree of a caution in our outlook. We noted that we wished to remain invested, with still reasonable long term expected returns from equities, but that following three very rewarding years, it was likely that 2022 would be more challenging. We also noted that a number of our preferred companies had seen meaningful valuation expansion in the preceding year and that we fully expected a period of consolidation, allowing time for earnings to catch up with valuation expansion.

Possibly most noteworthy, we commented that ‘perhaps an inflation overshoot and fears of a faster pace of interest rate increases could cause a temporary de-rating of markets (i.e., decline) but if this happens it will likely prove an opportunity’.

Well, we certainly got an inflationary overshoot, to put it mildly, and we saw, as my colleague Daniel Moroney has described, a seismic increase in interest rates.

The spike in inflation was clearly driven by a number of factors, including monetary and fiscal policy, but no doubt the increase in commodity prices, as a result of the war in Ukraine, was a significant and arguably unforeseeable factor.

It is truly remarkable to reflect that as recently as March, a 1-year German Government Bond was offering a negative yield of around minus 0.70%; as 2022 drew to a close, that yield was north of 2.50%. Whilst we expected interest rates to increase during the year, we did not expect rates to retrace the entire decline of the preceding decade.

This move in interest rates and bond yields no doubt catalysed a sharp de-rating (i.e., valuations fell) of asset markets, with government bonds, equities and property assets all experiencing double digit declines last year.

Whilst you may not see this decline in less liquid assets (yet!), such as open-ended property funds or private equity, public or listed markets adjusted very quickly to the rising cost of money. Furthermore, when the starting point was one of record low interest rates the impact is all the more severe.

It may not seem like a big move, but when an asset moves from a 4% earnings or income yield to a 5% yield, without any change in the earnings or income, that represents a 20% decline in the value of the asset. We need only look at the decline in European listed property assets, which declined a staggering c.40% last year, equivalent to a move in yields from just 3% to 5%.

The combination of an inflation shock, low starting interest rates and an aggressive central bank response proved a very challenging backdrop for asset prices in 2022.

Unusually our focus on quality didn’t help in the year. Ordinarily we might expect investors to prize the characteristics of the high-quality companies we own in a more difficult economic environment but 2022’s bear market was much more about valuation than growth.

Another challenge we faced during the year was the performance of our investment trust holdings, with many strategies experiencing meaningful discount widening. Investment trusts can trade at premiums or discounts to their net asset value and during 2022, due to heightened market anxiety, we saw a material move out in discounts. We remain convinced of the merits of investment trusts but no doubt this phenomenon exaggerated the mark to market declines in portfolios last year.

Returning to our quote from the beginning of 2022, we should now ask whether we see an opportunity following the declines of last year.

In January 2022, the earnings yield for the world equity market, which is a reasonable proxy for after-inflation returns, was 5.5%. Today the forward earnings yield for the world equity market is 6.7%, whilst the 12-month trailing earnings yield is 6%. So expected long-term returns have increased.

Of course, the debate now is about how resilient corporate earnings will be, should we experience recession, and clearly, we don’t know the answer to that right now.

It seems logical that when we see such a sharp increase in the cost of money that the economy will slow, and we will experience a recession. It is also likely that something ‘will break’, with so many investors becoming accustomed or conditioned to zero interest rates.

Perhaps one could argue that the ‘thing that broke’ was cryptocurrency and the associated fraud that has been exposed in recent months, and I think investors should be very wary of strategies that are dependent on excessive leverage (as should always be the case).

In terms of the broader, or real economy, we think we can be a little more optimistic. The consumer seems in reasonable shape and the large imbalances that were present prior to the financial crises are not present today, certainly not in a way that should present systemic challenge or threat.

It seems more likely that the global economy experiences a milder form of recession, which may ‘feel’ quite different to previous recessions, with the economy still expanding in nominal (before inflation) terms.

I should caution though that economic forecasting is fraught with difficulty and whilst I am slow to quote Buffett, as it is far too easy to do, I think he had it right when he quipped that ‘forecasts may tell you a great deal about the forecaster; they tell you nothing about the future’.

Our approach to the investing challenge is to invest in assets or strategies that we want to hold for the long term and to diversify amongst our preferred assets, varying this allocation dependent on our clients’ time horizon and circumstances.

In doing so we are, of course, mindful of short-term volatility and we know how uncomfortable this can be. However, we can’t avoid volatility, as to do so would also result in us avoiding return.

What has perhaps changed this year though is our menu of options. For the first time in over a decade we can actually get an acceptable nominal return from European government bonds.

That said, whilst positive, European government bonds and deposits still yield below inflation and over the longer term it is clear that equities, in regions of the world that respect shareholder rights, have been the best way of preserving purchasing power. We would also add high quality property and infrastructure assets, with inflation-linked income streams, as attractive assets to own, but still be wary of leverage.

It naturally follows that when these assets fall in value that we are being presented with an opportunity. The debate really is only whether we will get a greater opportunity. This is something we can only really speculate over.

We can see why markets may remain challenging for a period, should inflation remain stubbornly high, earnings decline sharply, or geopolitical tension escalates; and we can see why a sharp recovery that surprises everybody is also possible, should inflation recede quickly, earnings grow (or not decline) and geopolitical tensions ease.

I appreciate this may seem unhelpful and I know some readers want a more definitive outlook. Indeed, at a presentation late last year one attendee challenged me on why I didn’t give an outlook for what the US market would do in 2023 and provide a forecast level for the year end S&P 500.

Of course, I can understand why investors would like to know how markets will perform this year but candidly nobody truly knows, and we should be sceptical of short-term targets or price targets. I think it is important that responsible advisors are honest about this when asked. Our confidence in investing for the longer term is built on the knowledge that ultimately returns are determined by the underlying returns of the assets we own. However, in the shortterm returns can diverge from this underlying rate of return and this is why we emphasise the absolute need to be long-term focussed.

What we can say is that following a very difficult year, expectations are somewhat depressed, and valuations are much improved. Challenges remain but provided we have a long-time horizon, own good assets and are diversified, we should earn good returns and protect the after-inflation value of our capital.

At the start of 2022, we felt the need to temper expectations. At the start of 2023 perhaps it is time to remind ourselves that we should have positive expectations if we own the right assets.

We certainly remain pragmatic optimists. The longterm evidence is compelling in supporting this disposition.

As always, please do not hesitate to contact us with any questions you may have, and we wish you all the best for 2023.

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

www.brewin.ie

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