The final three months of 2022 were full of surprises. However, investment markets were generally ‘up’, offering some hope after pockets of political and economic turbulence. One of the biggest bumps along the way was the UK’s ‘mini budget’, announced in September…
Major Reaction to the UK’s ‘Mini-Budget’
The brainchild of Chancellor Kwasi Kwarteng, and rubber-stamped by Prime Minister Liz Truss, the UK’s ‘mini-budget’ covered a list of measures aimed at reigniting UK economic growth. Instead, it sent a chill through investment markets. All key asset classes suffered, but bonds – and UK government bonds (gilts) in particular – nosedived. Reacting to this drastic price drop, the Bank of England stepped in and bought gilts to the tune of £19.3bn, which was an unprecedented move.
Markets continued to signal their disapproval of the Chancellor’s plan, which forced his hand into abandoning an abolishment of the 45p ‘top rate’ of income tax. The move was broadly met with indifference, however, and so a full U-turn shortly followed, ultimately undermining the Chancellor’s credibility and costing him his job.
With the ‘mini-budget’ almost entirely left by the wayside, Jeremy Hunt – Kwasi Kwarteng’s successor – swiftly brought back a previous plan to raise UK corporation tax from 19% to 25% (to come into effect from April 2023) and cancelled the 1p income tax cut. He announced this alongside other measures that gave some reassurance to markets at a time when many politicians, media outlets and voters were calling for the Prime Minister’s resignation.
That day came when Liz Truss stood down on 20 October, after an eventful 45 days in office. The leadership election that followed saw Rishi Sunak appointed as the new Prime Minister, which boosted market confidence thanks to his reputation as a ‘safe pair of hands’ for the economy. Just a few weeks later, the UK’s Autumn Statement was presented by the Chancellor on 17 November. With a focus on stability, growth and public services, it was generally well-received.
Superpowers in Focus: US and China
Positive developments continued elsewhere in November, with ‘relief rallies’ in bonds and equities. In the US, Federal Reserve Chair Jerome Powell hinted that future interest rate hikes would be dialled down. The US tends to lead global markets, so even this clue landed well among them, though there continued to be nervousness regarding how long high interest rates would remain in place. Remember that markets dislike uncertainty more than anything else.
Perhaps counterintuitively, markets reacted well to the result of the US midterm election on 8 November, which saw the Republicans take control of the House of Representatives and the Democrats retain control of the Senate. This power split essentially amounts to ‘political paralysis’ – laws will take longer to be introduced and passed, while facing more hurdles along the way. The news therefore acted as a comfort blanket of familiarity for markets.
In China, meanwhile, the ruling Chinese Communist Party relaxed key elements of its ‘zero-COVID’ policy. The policy had been the backbone of China’s COVID-19 management strategy since the early days of the pandemic; however, following bouts of civil unrest at its strict measures, November’s rule amendments allowed for lockdowns in targeted areas only, rather than entire neighbourhoods or cities, as had previously been the case.
China’s new approach initially gave investors more confidence that it would be able to fully reopen for business and continue playing its crucial role in global supply chains. However, whether or not China is equipped to deal with the potential health repercussions of unlocking its doors – plus a population with limited immunity – remains to be seen. As the world’s second largest economy and a key cog in the global manufacturing engine, investors were concerned when, in late December, several reports stated that COVID-related deaths were on the rise in the country. This issue has the potential to have a knock-on effect on global inflation too, so it remains fixed on our Fund Managers’ radar.
Inflation, Interest Rates and Asset Classes
During Q4, rising food and energy costs added fuel to the inflation fire. In the hope of bringing it back down to earth, the US Federal Reserve (Fed), European Central Bank (ECB) and Bank of England (BoE) continued to raise their interest rates. The BoE’s Monetary Policy Committee voted for a 0.75% increase in November, which was the first time since 1989 for such a steep hike. This was followed by a 0.5% interest rate rise in December – a move matched by the Fed and ECB.
With a lens on Q4 investment market performance, the environment of high interest rates led to broadly negative returns for bonds. UK equities recorded some of the strongest performance among all assets in 2022 and Q4, but across the board equities performed poorly. Before the start of 2022, it would have been almost unthinkable that both equities and bonds would achieve such disappointing investment returns.
However, our Fund Managers and Analysts expected equities to outperform bonds, and they also forecast that UK equities would be the strongest performers in equity markets. They had positioned our portfolios, where possible, for this eventuality, which meant that our multi-asset and equity-focused funds were cushioned from some of the worst market blows. Our lower-risk funds – which have to hold a greater proportion of bonds, by design – were less protected (more information about the reasons for this can be found here).
Outlook: Cooling Inflation, Lower Interest Rate Rises
As proven last year, the world can be an unpredictable place. Russia’s invasion of Ukraine in February took most people by surprise. Perhaps more concerning is that the conflict continues to impact millions of people to this day, and any escalation would also be a risk to global economic stability in 2023.
Our Fund Managers and Analysts take worldwide geopolitical events, economic developments and a broad range of data into consideration as a core part of their work. While inflation may have shaped markets in 2022, there are many indicators – such as the cost of raw materials for manufacturers, and shipping costs – that show how rates should start to fall meaningfully in many countries this year, providing some relief for household budgets and investors alike.
The US has the advantage of relative energy security when compared to Europe. Partially thanks to this set-up, in Q4 US inflation fell to just over 7%. Markets are assuming that US inflation will peak at a lower level than previously forecast, leading to interest rate cuts in late 2023, though the Fed’s stance is less optimistic than this. Our Fund Managers are waiting to buy US assets and a stronger pound (sterling) would certainly help them get more ‘bang for their buck’ with the dollars needed for investment opportunities across the pond. Even though UK inflation remains higher than in the US, it dropped slightly to 10.7% in November. The hot topic for many professional investors is how quickly it will fall in 2023.
There are several risks associated with inflation, such as employees demanding higher wages and companies opting to meet their demands due to a highly competitive jobs market. This scenario can result in a widespread ‘wage-price spiral’, which sees employers raising salaries, meaning that inflation stays high. Workforce strikes in the UK – including NHS nurses, postal workers and train staff – have brought this issue to life, as many people want to achieve higher salaries to cope with the cost-of-living increase. However, our Fund Managers believe that the interest rate hikes seen in 2022 will help to reduce inflation in the months ahead.
Recessions are probable in many countries, as people are reluctant to spend on goods and services, which leads to a reduction in consumer demand and falling prices to mimic that demand. This is something the UK is already starting to see in its residential property market: according to data from Halifax, the average asking price was down by more than 2% in November compared to the previous month.
Sticking with the UK, the Office for Budget Responsibility announced its expectation for a longer-than-a-year recession while the Bank of England predicted that inflation would only begin to fall halfway through 2023. Lower inflation and falling interest rates are particularly good news for government bonds, which are set to recover some of their previous losses during this year. Our Fund Managers have started to position our funds to benefit from that projected outcome.
Our Investments Team
In summary, while there are some known investment-related risks for the year ahead – such as recessions, wage-price spirals, interest rate plateaus, dollar moves and rising unemployment – our team believes that the outlook for returns is much brighter than it was at the same point last year.
Though past performance is no indicator of future performance for investments, historic trends show us that when bonds are performing better – typically in a falling interest rate environment – we can expect that equities as an asset class will have a slightly tougher time of it. However, we are living in unusual times and the normal rules may not apply. What we can be sure of is that expert stock picking will be essential, which is why the role of our Analysts is so important: they research companies on a daily basis, lifting up the bonnet on businesses’ financial results and management strategies for the future, and sharing that important information with the whole Investments team.
Our Fund Managers, who are responsible for our funds’ performance, continue to follow their ‘contrarian’ long-term investment approach. This means they look further ahead than many investors elsewhere in the market, beyond short-term market ‘noise’. They maintain a preference for equities and commercial property as the drivers of greater investment returns in the future. With that in mind, they are making selective equity purchases alongside bond investments, putting money into overseas stock markets when appropriate. Last year’s property market falls also mean that more high-quality commercial opportunities should arise for our Property Managers this year.