Economic & Market Overview
• Having raised interest rates aggressively, the US Federal Reserve began to slow the rate of increases.
• European equities delivered some of the strongest returns, as mild weather in early winter helped to lower gas prices.
• Chinese equities rallied after Covid restrictions were finally relaxed.
Evidence that inflationary pressures may have peaked helped equity and bond markets rally, after what had been a difficult year to date for
markets as central banks raised interest rates to try to stamp down on inflation. Having raised rates aggressively, the US Federal Reserve
(Fed) began to slow the rate of increases, although they continued to emphasise that a change of direction for rates was unlikely whilst the
jobs market remained strong. European equities delivered some of the strongest returns, as governments in the region introduced measures
to moderate energy bills for consumers whilst mild weather in early winter helped to lower gas prices, alleviating fear s of an impending
recession. In China, sentiment began to improve as Covid restrictions were relaxed, and the government announced new support measures
for the property sector. These changes led to offshore Chinese stocks, listed in Hong Kong, being one of the best performing markets over
the quarter.
Although inflation in major western developed economies remained sharply above central bank targets, data pointed increasingl y to a mild
moderation in price rises. The change was driven initially by energy prices, but goods prices became a net detractor from inflation later in
the quarter, as global supply chain bottlenecks recovered and the extreme demand for ‘stuff’ experienced during the Covid pandemic abated.
US rate increases were tempered, as the Fed lowered the path of rate rises, having taken US rates from 0.25% to 4.5% in a mere nine
months.
Fixed Interest rallied as the interest rate outlook moderated. Investment grade corporate bonds performed strongly, having sold off more
than high yield bonds earlier in the year, even though the latter are considered riskier. Government bonds were in demand as well, their
‘safe haven’ characteristics appealing to investors as they weighed up the probability of central bank monetary tightening tr iggering a
recession.
Having stumbled at the start of the period in response to the sharp rate increases, US equities recovered their composure as policy tightening
slowed, whilst European equities, whose prices had already priced in a recession to a meaningful extent, climbed higher as energy prices
fell lower. For the Emerging Markets, it was ‘a game of two halves’. In the first half of the quarter, continued strength in the US dollar and
China’s ‘zero Covid’ policy weighed on prices, as they had for much for the year. However, as slowing interest rates rises caused the US
dollar to fall, and the Chinese government eased Covid restrictions in response to rising protests, EM equities moved sharply higher.
The UK started the quarter dealing with its own unique set of problems, the result of Prime Minister Liz Truss’s radical change of economic
policy. When firing her Chancellor was not enough to restore order, she resigned, making her the shortest serving Prime Minister in UK
history. With her replacement, Rishi Sunak, being seen by investors as a safer pair of hands, sterling rallied and bond yields fell back in line
with global peers, whilst the UK stock market finished the year as the best performing major developed country market.
Performance Review
The lower risk models delivered returns of 0.5% to 2.8%, whilst the medium risk portfolios returned 3.7% to 4.6%. The higher risk models delivered
returns of 5.4% to 6.2% over the quarter.
Equity markets ended a difficult year with gains in Q4. Asian shares were boosted by China’s relaxation of its zero-Covid policy, while developed
market equities rose on hopes that inflation may be peaking in the US as well as Europe. For our medium and higher risk model s, the standout
performers were LF Lightman European, Schroder ISF Global Energy Transition and Polar Capital Global Insurance, returning 18.9%, 15.0% and
10.7% respectively.
Within Fixed Interest, government bonds continued to struggle, as major central banks reiterated plans to tighten monetary policy, even as inflation
showed signs of peaking. However, corporate bonds fared better, bouncing back after a torrid few quarters, and the standout performers in the
portfolio were in this sector, with BlackRock Corporate Bond and Royal London Corporate Bond returning 9.2% and 6.0% respectively.
Finally, Absolute Return was a mixed bag, with some funds gaining and others falling, but in total our holdings were a mild drag on performance.
Portfolio Changes
Tactical Asset Allocation
• Increased Fixed Interest, reduced Absolute Return, Strategic Bonds and cash.
Outlook
In recent months, inflation has shown signs that it has peaked and is starting to fall. However, this change has been due largely to falling
energy prices, whilst so called ‘core inflation’, that excludes food and energy, remains elevated and, in some countries, is still rising. That
notwithstanding, there are good reasons to believe that the fall in inflation will continue, not least the significant fall in monetary and fiscal
stimulus post the Covid pandemic. Even so, it is impossible to know at what point central banks will pause the rate hiking cycle, particularly
while labour markets remain tight, and wage rises high. Therefore, investors are left to ponder whether a soft economic landing can be
achieved, or whether further rate rises (or even the current level of rates) will lead to a recession later in the year.
The US economy is a key focus for investors and judging whether or not it will tip into recession is difficult. However, even if investors get
that call correct, it does not necessarily help them. Markets are forward-looking, so price in likely outcomes well ahead of time. Therefore,
even if the US economy were to shrink some time in 2023, it does not mean that stock markets will necessarily follow. We know today that
equity valuations have fallen significantly, with many, but not all, country indices trading below their long-term average. What we are less
sure about is the level of company earnings going forward, and if they were to weaken more than anticipated, there could be another leg
down in markets, even if a recession is avoided. However, as well as equities having become less expensive, Fixed Interest has undergone
a rapid and painful repricing that has brought yields back to levels that we have not seen for a decade or more. As a result, the asset class
provides meaningful diversification benefits when held alongside equities for the first time for a while.
The biggest and most obvious risks for investors this year look very similar to those of last year. If inflation remains at elevated levels, central
banks would probably be forced to continue raising rates, with the prospect of tipping economies into a deeper recession. Geopolitical risks
remain, namely a further escalation in the war in Ukraine, or deteriorating relations between China and the West, especially whilst an
invasion of Taiwan cannot be ruled out. Perceptions around the last point may be particularly important, as without such deterioration,
Emerging Market (EM) equities could continue to benefit from a weaker dollar and the stimulatory effect of a Chinese reopening. Combined
with attractive valuations in many EM stock markets, such circumstances could provide significant potential upside.
In the portfolios, having been underweight for a prolonged period, we have increased exposure to Fixed Interest, as the yields on offer provide
genuine diversification benefits alongside equities, and the additions in government and high-quality corporate bonds should provide some
protection in the event of a recession. Within equities, we remain diversified, but with a s ignificant exposure to Asia and EMs that looks
better placed to benefit this year.