A year in review

The following content has been provided by LGT Wealth Management. This article looks back at last year’s economic landscape and how developments have affected investors.

Credit: LGT Wealth Management

Over the course of 2022, we saw the investment landscape shift away from a decade of ‘easy’ money from the low interest rate environment of the 2010s into surging inflation. Rising interest rates, market volatility and increasing prices driven by a variety of factors including a war in Europe, has been a recipe for a tough investing environment. In this annual review, we reflect on the events of the year and how the Model Portfolios navigated the market turbulence. 

It has been an incredibly challenging year in terms of investing. To put this into perspective, 2022 was one of the seven years in the last 42 years where a traditional 60/40 portfolio has not delivered a positive calendar year return, with both bonds and equities losing money.

The positive correlation of both asset classes has made finding shelter all the more difficult, with cash and absolute return strategies becoming essential. As can be seen below, energy was the only positive performing sector in the S&P 500 this year. However, we do not want to hold companies that are entirely reliant on external factors to determine their value (e.g. energy, commodities). This has hurt us this year, but our investment philosophy remains intact.

Data by Factset (21/12/2022)

At the time of writing, the S&P 500 is down around -18% YTD^[1]. However, around 60% of the underlying stocks have outperformed the index, the most since 2001, and points towards a stock pickers paradise for the most experienced managers.

Rising inflation and a war in Europe

Investment markets had a difficult start to the year with a backdrop of rising inflation and potential tightening by central banks. Some relief was provided by the Q1 earnings season, before the Russian military invaded Ukraine, weighing on markets again. Supply chain issues that were initially triggered by Covid-19 were amplified by rising demand as the world began its recovery out of the pandemic, pushing prices higher. It was hoped that this would be a temporary move and, as supply chains normalised and excess pent-up demand faded, inflation would fall back. However, the Russian invasion of Ukraine saw a huge rise in the Brent crude oil price, which was down to $20 a barrel in 2020, $78 at the start of this year and peaked at $139 after the invasion^[2].

After inflation peaked at 8.5% in the US, inflation data for November came in lower than anticipated for the second month in a row taking the annual number lower to 7.1% (vs expectations of 7.3%). The Federal Reserve (Fed) went ahead as expected with a 0.5% hike at the December meeting. Whilst the slowing of the pace of hikes from 75bps to 50bps was well-flagged, the Fed tried its hardest to push back on the easing in financial conditions that has happened since October.

In the UK, the fall in CPI inflation, from 11.1% in October to 10.7% in November (consensus 10.9%), means that inflation in the UK has likely peaked and should fall from here^[3]. Nonetheless, despite some signs of economic weakness, the Bank of England (BoE) went ahead and raised rates by 0.5% at the December meeting. The tight labour market continues to pose challenges for both the BoE and the Fed, as wage growth remains elevated. The Eurozone followed suit and slowed its rate rises to 0.5%.

The Bank of Japan (BoJ) has maintained its ultra-loose monetary policy this year, where other major central banks have been embarking on their aggressive interest rate hiking cycle. This disparity in monetary policy has resulted in a significant slide of the yen this year, especially versus the US dollar. In a big shock in mid-December, BoJ made a change to their yield curve control policy. Whilst overnight interest rates have been kept at -0.1%, the central bank are now allowing 10-year bond yields to fluctuate between +/- 0.5% from the 0% target, instead of +/- 0.25% previously.

Central bank action implications on asset prices

While the direction of travel is similar, the pace of central bank tightening has varied. The BoE began raising rates in December 2021 with a 0.15% move. Since then, they have raised rates nine times. The Fed was slower to raise rates but accelerated its incremental moves, raising its target rate by 0.75% at multiple points during the year. The ECB suspended its bond-buying programme in June and made its first rate rise in July. The issue faced by central banks is that the tools available to them can impact demand but cannot ease the external supply side factors that have been pushing inflation higher.

With flaring geopolitical tensions and central banks’ tightening policies, there were unsurprisingly some very large moves in equity markets this year. The pandemic’s losers became this year’s winners, and the S&P energy sector was the only sector to rise in 2022, buoyed by the highflying oil price earlier this year. Beneath the surface of the headline numbers however, masked even greater volatility in individual names. As an example, Netflix is down -51% YTD, Meta -67%, Alphabet -38%, Amazon -50% and Tesla -66%^[4].

UK political turmoil

In the UK, former Prime Minister, Liz Truss, and her Chancellor, Kwasi Kwarteng, delivered a ‘mini-budget’ in September in an effort to boost the economy. However, this was seen as boosting inflation at a time when the BoE was raising rates to fight inflation. Borrowing to cut taxes was not favourably received by markets and triggered a sharp sell-off in both sterling and gilts. Pension funds have been encouraged since 1997 to hedge their liabilities using fixed income strategies. In recent years, pension funds have taken leveraged exposure to fixed income to match the interest rate risk. As interest rates rose, there were collateral calls on pension funds and the sell-off became exaggerated. As the bond price falls became precipitous, the BoE had to step in to support the market by buying gilts. This provided some stability and some of the losses were reversed.

China and its response to Covid-19

 Throughout the year, we have experienced a varied approach to controlling Covid-19 from the Chinese Communist Party. This has undoubtedly resulted in huge volatility within the region as restrictions were either tightened or relaxed. A reopening of China and subsequent easing of supply chains will be a key stimulus to global growth. It appears that we are approaching the beginning of the end of Covid-19 restrictions in China, even if the journey from start to finish is likely to be complicated and volatile. Whilst the timeline for a Chinese reopening is impossible to predict, when it does happen it could go some way to plug the demand gap left by slowing growth across US and Europe.

Looking ahead

Global growth is likely to continue to be soft this year, but we are not predicting it to fall off a cliff. The US has been able to manage down inflation more effectively than other Western economies and as such, the economic performance of America is likely to be more robust next year than that of the UK and wider Eurozone. Throughout 2022, the US consumer has been vigorous, buoyed by saving rates that increased during Covid-19 lockdowns, and we see a scenario in which this continues through next year allowing unemployment to not rise as much as the market expected. Across most of the world, central bank action is likely to act as a constant headwind to corporates, households and markets, but in fact, this is the type of environment we believe value will emerge.

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