Welcome to our latest investment commentary covering the first quarter of 2023. We hope you and your family are well and that you had a peaceful Easter break.
Off the back of a difficult year, market-wise, we are pleased to report that this first quarter has been a positive one for all of our portfolios, which follows a positive Q4 2022.
In our Q3 2022 update, we spoke of potential catalysts that could help the markets begin their recovery. Two of the three mentioned came to fruition in Q4 and have largely continued into the new year.
As a reminder, the first was that the US Federal Reserve could slow the pace of interest rate hikes. The aggressive interest rate hikes going into 2022 were the primary reason for the volatility seen over the course of last year, and so a slowdown has been seen as a positive. The Fed is likely to hike a few more times, however, the rate hike slowdown is now in progress.
The second was the end of Covid restrictions in China. Asian markets got off to a strong start this year but have given some of these gains back as they digest the news flow relating to the reopening.
More detail on the above can be found later in the note.
Whilst general conditions remain difficult, it has been our ongoing stance to remain invested throughout this period because we do not know when these, and other less obvious catalysts could come to fruition. We have instead worked hard at helping the portfolios navigate the current environment.
Q1 REFLECTIONS
January was an exceptionally strong month for markets, with most asset classes rallying. This was particularly evident in the areas that had been most affected last year such as technology stocks. February was a trickier month, as some concerns returned to markets. This was soon followed, in early March, by the collapse of Silicon Valley Bank (SVB) in the US and the fall of Credit Suisse in Europe. This led to significant volatility in the bond markets, the magnitude of which was last seen in the early 1980s, as well as weakness in the Financials sector. Despite these events, the portfolios did well and ended the quarter in positive territory.
Whilst lower interest rate expectations were the theme in January, a higher interest rate outlook began to make a come back through February, leading to some market weakness. This rapidly flipped again due to recession concerns in March and expectations for interest rate cuts as the banking issues unfolded.
We did not make many changes over the quarter. Many of the positive changes were done last year. We are pleased with the current positioning in the portfolios and continue to look for opportunities that develop as a result of the market conditions. Our main focus is currently on Government Bonds, which we go into more detail below.
Q1 REVIEW
Market Performance
Year on year US CPI (inflation) continued to fall over the quarter, coming down to 6.0%. It was again encouraging to see the core components also easing back in the recent data releases, which are more of a focus for the US Fed. Some data has suggested a small pickup in US inflation recently, which is not a surprise because it is unlikely the direction of travel will be in a straight line down. Once again, UK CPI appears to be going in the wrong direction and has continued to creep up to a rate of 10.4%.
Equities and bonds continued to move in tandem, upwards in January and then down in February. However, for the first time in a while, we saw some evidence of Government bonds disconnecting from equities during the banking issues, with equities moving down and bonds up. This has been an expectation of ours and why we have been adding to Government bonds where applicable. We will continue to add at opportune moments.
We continued to see sector dispersions, with the more cyclical sectors such as Energy and Financials this time not doing so well due to recession concerns. In contrast with the 2022 theme, the Consumer Discretionary and Technology sectors were the best performers. The repeated swings between the different groups of sectors is something we have been seeking to avoid and which backs up our stance to be generally sector neutral, with a slight overweight to the Defensive sectors such as Healthcare and Consumer Staples. This approach has led to a drop in our volatility levels and good relative performance.
Gold has been big a beneficiary in Q1, rising over 8%. There were expectations for Gold to perform well in 2022, as inflation took centre stage. However, it didn’t deliver as the speed of interest rate increases outpaced the pickup in inflation, a scenario which is not favourable for Gold. Whilst inflation is coming down in the US, interest rate expectations are falling faster due to recessionary concerns, causing the Gold price to rise. It has recently crossed above $2,000 per ounce again. We currently own Gold in several portfolios where applicable.
2023 OUTLOOK
Inflation & Central Banks
The inflation picture is becoming Geographically dependent, with some countries seeing falls in inflation and others increases. Each region increasingly has its own idiosyncratic reasons behind their respective inflation stories.
Energy and broader commodity prices have continued to fall, helping to reduce the year-on-year inflation data for those most sensitive to these prices such as Europe. Furthermore, the core components of inflation are also showing signs of easing back in several regions. This is of course pleasing for the Central Banks and adds weight to the US Federal Reserve at least pausing interest rates in the near future.
Again, we are seeing different messages from the various Central Banks, with the US Fed sounding more likely to pause than the European Central Bank. The Fed’s latest statements suggest they intend to stop raising interest rates this year and then maintain the terminal rate for a prolonged period of time to ensure inflationary pressures continue to abate. The markets however do not believe this narrative and have already priced in some interest rate cuts by the end of the year. This contention suggests the environment could remain volatile and certain industries could come under pressure, as we saw with the US regional banks.
We expect inflationary pressures to continue easing over the coming months but to settle above the medium term historical average of 2%. We would not be surprised if inflation remained above 4% over the coming years and averaged a higher figure.
Recession Risk
We are seeing increasing signs of recessionary risks, with indicators across a range of segments deteriorating. This should not come as a surprise due to the aggressive monetary policy we have seen.
Recessions do not always spell bad news for the markets because it depends on the type of recession experienced. We have positioned the portfolios defensively as mentioned earlier and do not expect to increase the risk levels until the outlook improves.
A key area we have focussed on is the quality and size of the underlying businesses we are exposed to. Poorer quality businesses may suffer due to higher input costs combined with slowing demand. We have been concerned about this for some time and have worked hard to ensure the portfolios are predominantly invested in high quality businesses. Furthermore, large, international businesses tend to weather such environments more successfully than smaller companies. We have therefore minimised our exposure to smaller companies.
Another area that tends to perform well during recessions is Government bonds. They are seen as safe haven assets during such times and we have been steadily increasing our exposure to them and will continue to do so in the coming months. They are particularly effective when Central Banks begin cutting interest rates.
Strategy
As mentioned at the start of the update, we have remained fully invested but have adjusted the positioning to reduce the volatility levels and better navigate the current environment. Some points to note around our thinking moving forwards, which generally follow the comments in our previous updates:
- We continue to believe elevated volatility levels are likely to become a feature of markets over the next few years and so we will maintain a lower volatility approach more frequently.
- We have already leaned into a range of bonds with a greater focus on Government bonds, which can act as an effective hedge against equity market volatility. We will continue to add here.
- Outside of Government Bonds, we have concentrated our exposure in short dated investment grade bonds, which are the safest corporate bonds to invest in. The yields remain attractive.
- In terms of our equity allocations, our largest equity exposure remains towards US markets however we are maintaining good allocations to other markets such as Asia. Diversification is key in this environment.
- As previously mentioned, we now have no direct exposure to Europe due to the ongoing war in Ukraine. On a look through basis, some of our global funds have select European exposures and these are typically in the high quality international companies such as Roche and ASML.
- We are not changing the allocation to the UK and have maintained a focus on the large, international FTSE businesses. We remain concerned with the domestic outlook and feel there are risks that may not be obvious. We are therefore avoiding small and mid sized businesses.
- We continue to hold a reasonable amount of Asian equities. With the change in China’s Covid policy coupled with fewer inflationary pressures, we are more optimistic in the short to medium term on the region.
You should note that when we see signs of improvement and the potential for interest rates to fall, we are likely to increase our risk levels and focus on areas that typically do well during the recovery periods such as Financials, Industrials and Materials businesses.
You should note that when we see signs of improvement and the potential for interest rates to fall, we are likely to increase our risk levels and focus on areas that typically do well during the recovery periods such as Financials, Industrials and Materials businesses.
Summary
Whilst the markets have been drifting higher since October 2022, we are monitoring the fast-changing developments and the prospect for recessionary risks to take centre stage.
We will continue to look for new opportunities for the portfolios whilst trying to navigate the environment the best we can.
MARKET INSIGHTS – WEBINAR INVITE
As a reminder, our next investment webinar will be hosted on Monday 17th April at 14h00. This quarter Tommy and I are joined by special guest, Sanjay Rijhsinghani of LGT Wealth Management. Together we will discuss market trends and the current outlook, as well as reviewing our Portfolios and ideas we have for them going forward. The Q&A session at the end opens up the floor for you to ask any investment/ market related questions. If you haven’t already, please click HERE to register for this.
CHANGES MADE
We have made some changes during the quarter. A full account of which can be found below:
We hope you find this review informative and look forward to hearing from you if you have any questions.
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