Investors will be glad to see the back of 2022. The year can be summed up by the Collins dictionary’s word of the year, ‘permacrisis’, which is defined as an extended period of instability and in security, especially one resulting from a series of catastrophic events. Permacrisis reflects the feeling of an ongoing state of uncertainty and worry – the upheaval of Brexit, the global pandemic, the war in Ukraine, political instability, high inflation impacting living standards, rising food and energy costs, as well as extreme weather as a portent of the climate emergency.
2022 Unprecedented Year
In 2022 we have witnessed a series of unprecedented events with far-reaching consequences. The Russian ‘Special Operation’ or invasion of Ukraine represented the largest land war in Europe since the Second World War. The German response was a historic turning point, ‘Zeitenwende’, a pivot away from Russia politically and the use of Russian energy, as well as a reversal of Germany’s previously cautious defence policy with €100bn in military spending, an assertion of Germany’s and more widely Europe’s geopolitical strength. In terms of the global economy, the double digit level of inflation in much of the world has not been seen for over 40 years.
In the UK, the passing of Queen Elizabeth II closed a remarkable reign of 70 years. Politically, the UK experienced extreme instability in 2022 with three Prime Ministers and four Chancellors of the Exchequer. Liz Truss’ premiership lasted just 49 days, the shortest in British history. Markets took fright at Chancellor Kwarteng’s aggressive tax cutting ‘Mini’ Budget – Sterling hit record lows and there was a fear of some pension funds collapsing as gilt market volatility rocked the financial system. Mortgage interest rates jumped higher squeezing borrowers and sending jitters through the UK property market.
High Inflation and Recession Risk
Whilst the causes of soaring inflation this year can be traced back to years of loose monetary policy, low interest rates and quantitative easing (‘QE’) after the global banking crisis and latterly during the pandemic, the war in Ukraine led to a spike in energy prices which sent shockwaves through the global economy. This brought decades of low inflation and low interest rates to an end. The extensive use of oil and gas in industrial applications, agriculture, as well as domestic consumption in turn has resulted in a cost of living crisis and falling living standards. The impact on economic growth has been severe, with growth slowing in almost every part of the world.
Dismal Year for Investment 2022
Against this backdrop of political and economic turmoil, it is unsurprising that 2022 has been a bad year for both equities and bonds. Overall, global equities have declined 17%, with US equities down 20%, although the tech-laden NASDAQ has lost 34%. Europe, Asia and emerging markets have fared only slightly better. Japanese equities have declined around 3% having decoupled from the strong downdraught of US equities. The UK FTSE-100 index with its large weighting in natural resources, as well as banks, pharmaceuticals, other defensive sectors and a notable absence of technology companies, has finished the year largely flat; the more UK domestically focused FTSE-250 index on the other hand is down nearly 20%.
Bonds Hit Hard
Long-term bonds have had their worst year since the 18th century as central banks have repeatedly raised interest rates to tame rising inflation, as well as moving from quantitative easing to quantitative tightening, so as to shrink their balance sheets. This means that the typical balanced portfolio with 60% equities and 40% bonds has experienced its worst year since the 1930s. This is reflected by a decline of over 20% in UK government gilts in 2022.
For a UK based investor, the extreme volatility in equities and bonds has been magnified by unprecedented currency fluctuations in respect of sterling. During 2022, sterling has fluctuated by around 25% against the US dollar; even allowing for a rebound in sterling under the new Sunak administration, sterling has declined by over 10% against the US dollar and 5% against the euro in 2022. The rebound in sterling in the last quarter of 2022 has acted as a significant headwind for UK based investors in global equities.
Outlook for 2023
The IMF predicts economic growth of 2.7% for 2023, the lowest growth forecast since 2001, with the exception of the global financial crisis in 2008 and the middle of the coronavirus pandemic. The low forecast for economic growth reflects the expectation of a recession in the UK and Eurozone, as well as the fact it is likely to be touch and go for the US if it avoids a recession.
Central Banks have Key Role
Central bank banks around the world will play a key role in determining how 2023 unfolds for investors. They face a balancing act of needing to increase interest rates further so inflation can brought under control, but at the same time moderating interest rates, so as to support economic growth and make any resulting recession as short, shallow and painless as possible.
A key risk for markets in 2023 is that just as with the benefit of hindsight central banks started increasing interest rates too late and too slowly in 2022, central banks now proceed to raise interest rates too high, thereby making the economic slowdown worse than necessary. In particular, raising interest rates does not reduce the cost of energy, which makes up a significant component of inflation data both directly and indirectly. Increased spending on defence and re-mapping supply chains by ‘re-shoring’ are also likely to put upward pressure on inflation for some time to come.
Commodity Prices to Stay High
The worst of the energy crisis may be over, but the squeeze on commodities is likely to persist next year as global supply chains gradually recover. An important element here will be the easing of Covid restrictions in China and the pace at which this happens, mindful of the potentially serious health consequences for millions of unvaccinated Chinese citizens.
Commodity prices are also likely to remain high as inflation may prove stickier than anticipated, especially with the potential from wage-price inflation as a result of action by trade unions and strikes. Energy transition and longer term structural changes in energy supply will also support higher prices.
Political Risks Remain
Geopolitical tensions are likely to continue with little prospect of a quick resolution of the war in Ukraine. There is the possibility of a victory for a right-wing government in Spain’s general election, following the election of far-right leader Georgia Meloni in Italy. Further afield political tensions may flareup in Taiwan or the Middle East.
Of course, it is important to consider the potential for positive political developments, such as peace talks in Ukraine in the event of a stalemate situation, as well as the possibility of the Chinese government deciding to pursue a pro-growth agenda after the prolonged impact of the pandemic in China.
Mixed Outlook for UK
The UK is likely to face a challenging year economically, especially if rising interest rates and a recession cause a significant wobble in the housing market. An increasing level of mortgage defaults could potentially impact banks and the wider financial sector, such as car leasing and other companies providing personal credit. Public sector strikes and crumbling public services undermine the potential for economic recovery too. The energy market remains uncertain too with consumers temporarily protected from soaring prices; it remains unclear how the cost of energy transition to Net Zero in line with agreed climate targets will be met.
However, in terms of valuation the UK equity market is attractive against itself historically, as well as other global markets. This is because in the aftermath of the Brexit vote international investors tended to shun the UK preferring to invest elsewhere. There are signs now of foreign investors returning, so as to take advantage of lower valuations, helped by sterling weakness.
Defensive Equities Should Prosper
In 2023, companies likely to fare best are large multinationals with strong balance sheets which can weather a tough economic climate, especially if they are engaged in sectors where they have pricing power to pass on price rises to their customers. Such companies may be found across diverse sectors and exhibit attractive defensive characteristics. This may include healthcare, consumer staples, natural resources, financials and some industrials.
Asian Markets Poised to Recover
In terms of valuation, many Asian markets, including China and Japan offer the prospect of recovery in 2023 in the aftermath of the pandemic and the potential for economic growth in excess of the global economy. Many countries in Asia have low levels of debt than the West, more favourable demographics and companies in growth markets. Many Asian economies were hit hard by the pandemic and only now are re-opening from an economic perspective. This re-opening trade should provide a short-term fillip, with the longer term reflecting the potential for Asian economies to grow faster than most Western economies.
Technology Investments Provide Selective Opportunities
Whilst technology investments have been very significantly marked down, market participants are divided with regard to the outlook. On the one hand, established profitable multinationals such as Microsoft are likely to continue to prosper; on the other hand, the valuation of some technology companies remains elevated indicating that a final capitulation has not yet occurred. Many employees holding stock options in Silicon Valley are keen to exercise them even at current prices reflecting nervousness; this potential stock overhang is likely to act as a headwind for valuations in the short-term.
Alternative Investments Provide Diversification
With regard to alternative investments, commodities should continue to prosper as the price of raw materials rises. Infrastructure and renewable energy projects provide useful portfolio diversification, but care is needed to check that companies are not excessively borrowed since the cost of finance has increased. Also, inflation-resilience and income generation will be a trade-off for many alternative investments.
Commercial Property Faces Headwinds
Commercial property may face a tough year as borrowing costs rise for property companies and many tenants are squeezed with recessionary conditions. In addition, many businesses are reviewing the extent to which they require office space in the aftermath of the pandemic; the demand for retail premises remains weak. The increasing ‘EPC’ requirements represents an unwelcome additional cost to landlords needing to improve the environmental footprint of their real estate.
Bonds Should Perform Better in 2023
The outlook for bonds should improve as 2023 progresses once interest rates peak. Indeed, a quality bond which may now yield in excess of 4% is potentially attractive in any low growth environment. This is good news that bonds again are a reliable source of income in portfolios. As QE has ceased and central banks seek to normalise monetary policy, the dynamics affecting bond markets should revert to more traditional models ultimately benefiting investors.
Better Times Ahead in 2023
Overall, 2023 should be a better year for investors with pockets of selective value in equity markets, as well as a brighter outlook for bonds. Our expectation is for a year of two halves – the first part of 2023 characterised by further episodes of volatility as central banks grapple with interest rate policy to tame inflation, whilst the second half of 2023 and into 2024 should see the emergence of a recovery phase and a gradual rebuilding of confidence.
A recovery is anticipated on the basis of the economic cycle moving positively out of recession with interest rates at a peak and an improvement in global trade following more normal conditions with global supply chains as the Chinese economy gets back on its feet after pandemic.
In the UK, with the dawn of a new Carolean era, the hope is that the Coronation in May promotes a feelgood factor bringing the country together and providing the impetus for better times ahead. I wish everyone a healthy, happy and prosperous 2023.
Matthew Clark, 29 December 2022
Please note, our Market Overview & Outlook is our view of markets and does not constitute investment advice. Past performance is not necessarily an indication of future returns; the value of investments and any income from them is not guaranteed and can fall as well as rise. Overseas investments are affected by currency movements and exchange rates. If you would like investment advice on your individual circumstances, please do not hesitate to get in touch, telephone 01392 875500, info@SeabrookClark.co.uk