Refocusing on fundamentals in challenging markets
When you can’t list all the top concerns for markets on a single hand it’s easy to be pessimistic. We do not underestimate the risks, not least that of a future US recession, but we still see good value in equities as the economic recovery continues for now. However, in the face of these challenges, we are focussing our portfolio on companies that can deliver profits in the face of inflation, rising interest rates and supply chain disruptions.
Markets face a laundry list of structural and cyclical challenges
First, tightening liquidity and moderating economic growth present a challenge to equity markets. It will also drive volatility in the near-term as investors look for signs of a recession or ‘soft-landing’ in every data point.
Second, every cycle is different, but we do face a very real prospect of a secular change in the backdrop for financial markets. From the early 1980s inflation and interest rates began a long decline and this coincided with a significant re-rating in global equity markets, led by the US. A secular upturn in inflation and interest rates will have negative implications for the rating of equities.
Third, the global economy of the last few decades has not proven resilient to attempts to ‘normalise’ monetary policy and each tightening cycle has led to lower peaks in interest rates and lower lows on loosening. So high debt burdens could lead to a less aggressive tightening cycle than currently assumed.
Fourth, bond markets normally adjust expectations with respect to central bank policy relatively slowly. Instead, we have seen a historically rapid change in expectations. Equity markets have performed relatively well, despite this rise in discount rates, as they are a better hedge to inflation.
Fifth, while the Ukraine conflict has presented a terrible spectacle in terms of humanitarian costs the market has largely performed to type, with a kneejerk negative reaction and subsequent recovery. There are broader economic implications to the conflict, felt through higher inflation due to rising commodity prices and further disruption to supply chains, as well as structural changes, pushing de-globalisation and increased spending on defence.
Sixth, China continues to pursue a zero-Covid policy which appears both illogical and highly disruptive to their growth. The ongoing prospect of lockdowns presents significant risks to growth and risks further pressuring global inflation due to disruption to supply chains.
Seventh, rising food prices disproportionately hit the poorest, and present a threat to stability in emerging markets. We have already seen social unrest in South America and subsidisation of fuel prices will put government and consumer finances under severe pressure.
US recession is the top risk, but history suggests we are at least a year away from the peak in equity markets
While the top concern for investors is that current tightening cycle leads to a US recession, we do not think it is an imminent risk. History suggests that we are still too far away from this event for markets to price this in. Indeed, markets do tend to perform well for a good period after the yield curve inverts, and recession comes into view. On this basis, we are still at least a year away from the peak in equity markets. History, however, is only a guide and we have an unusual combination of already slowing growth, rising rates and moderating inflation which will likely worry investors and make markets volatile.
Cutting unnecessary risks and focusing on fundamentals in the portfolio
So, how have we responded to this laundry list of concerns in the portfolio? We have cut unnecessary risks and refocused the portfolio on the strong, core fundamentals of equity markets.
- Reduction in gearing levels. We believe that it remains appropriate to hold a positive gearing position for the fund for the time being, given still deeply negative real-interest rates, but have already cut leverage.
- Reduction in the sterling hedge. The outlook for the dollar is uncertain but sterling tends to decline in a ‘risk off’ event.
- Reduction in small cap exposure. While small caps have underperformed and are trading at low valuations versus large caps, we view them as less well placed to withstand rising input costs and, consequently, profit margins are at risk.
- Further sale of US large cap growth. We have switched to favour value stocks in the US as the valuation spread between these areas remains high and macro variables are not supportive.
