2022 has been a very tough year in lots of ways.
- Europe is at war for the first time in 75 years.
- Inflation of 10% plus.
- Energy prices skyrocketed.
- Britain became a political joke with a new prime minister and chancellor blowing up economic stability and imperilling pension scheme solvency.
- The pound crashed 20% against major currencies in a matter of days.
- The majority of equity markets had big down years.
- Interest rates globally rose 400% plus in 6 months.
- Mortgage rates rose 500% plus in 6 months
- Bond markets had generational reductions.
I could go on, but this last year really has been chock-full of grim.
2022-THE FACTS
When equities have a bad year bonds usually do ok, but both have been down together.
This was the worst year in combination…. EVER!!!
The standard 60% stocks/40% bonds portfolio has been hammered.
SUPER HIGH INFLATION AND RISING RATES OF INTEREST
So why did we get this carnage?
Firstly, inflation was stoked by a supply shock (people wanting to buy what wasn’t available), then a demand shock (people being given money and at home not spending on normal things like travel and entertainment) so buying goods.
Once Covid was more manageable, everyone went out spending big on travel and services.
With inflation starting to really bubble the accelerant was an energy price shock from the Ukraine invasion.
Stir vigorously and ….
10% plus inflation rates everywhere you looked.
GOING INTO ‘23
It helps to understand that inflation statistics are slow in some cases to reflect changes especially the shelter element (housing and rents). This means that the big rises post-Covid showed up in the data much later than they happened (back end of 2020) and is now staying high even though real time data verifies significant reductions everywhere.
Inflation is falling fast in every element which makes up the calculation and will shortly compare on an annualised basis to higher numbers in 2022, like $120 Oil which is currently $75.
CENTRAL BANK TIGHTENING
Central banks reacted to the inflation surge by aggressively pushing up borrowing costs. Central Banks don’t actually set interest rates for the economy, they set the rates for their interaction with banks. The market sets economic rates by changing the price of debt. As an example, the U.K. 2-year GILT yield went from 1.3% in January to 4.75% by late September. The speed and magnitude of the changes were overwhelming.
It has been the most severe tightening cycle in financial history.
MARKETS IN DEPRESSION
Literally everyone by late 2022 had become hyper negative on asset valuations and very bearish for 2023.
This in itself doesn’t signal a bottom but suggests that many who were going to sell have probably sold.
It is often a successful strategy to be contrarian when sentiment is overwhelmingly positive or negative.
THE GREAT AND THE GOOD GET HUMBLED
The share prices of the biggest and best companies have been eviscerated. If you are amongst the best companies the world has ever seen and had a strong year with growing earnings and strong guidance like Apple and Microsoft, you were down 30%. If you actually had a poor year like Meta, Amazon or Disney, then 50% plus.
If you had been a pandemic hot stock then armageddon:
The share price appreciation of an Apple or Microsoft demonstrates that over time the economics of a company will dictate the share prices. The value of a business must increase if they are reinvesting earnings at a superior return on capital employed. Growing by reinvesting profits year after year at 10-15% returns.
But the market will also emotionally fluctuate from happy to sad and share prices will reflect this. Market valuations over time are going to tell the truth of growth in profits and valuations but over short periods they sometimes don’t. The key to remember in sad times is that if the business metrics continue to go in a positive direction then so MUST the share price.
IT FEELS BAD
The average person dislikes how losses make them feel 5 times more intensely than the pleasure they get from gains. If we remember, in the year of the pandemic (2020) the portfolios were up circa 12-15% and similar in 2021, then 2022 was arguably really what 2020 should have been. If 2020 was down 30% because the economies of the world shut down nobody would have thought that odd.
This also highlights the impossibility of investing by market timing buys and sells.
As Terry Smith points out, to do this successfully you need to know what is going to happen in advance and then also how markets will react – neither of which is knowable. 2020 demonstrated that to be a tough task indeed.
THE KEY TO SUCCESS
It’s often said but it’s so important. Great investment results are gained from allowing top quality assets to grow over time and not freaking out and cashing out when markets plunge. It’s always happened, it always will. It’s why it’s hard and is the emotional cost paid for ultimate success.
Warren Buffett is oft quoted as saying “the most important quality for an investor is temperament, not intellect”, and “a disciplined investor is a wealthy investor because they have learned that market fluctuations are normal, and that patience pays off”.
PUMP IT IN THEN RIP IT OUT
As an example of how the excess liquidity pumped into the US economy has been aggressively withdrawn by the Federal Reserve see the M2 figures below. Economies and asset prices grow with more liquidity and shrink with less. The 25% liquidity injection in 2020 is being siphoned back out in a hurry and this disrupts markets whilst it’s happening.
What’s interesting is that US individuals were estimated coming into 2022 as having $3.2Trillion of pandemic stimulus excess savings, now down to $1.8 Trillion.
These large surplus savings are the most plausible explanation for spending staying robust and labour tight. It’s also harder to see a recession in ‘23 with both the above remaining true.
WHAT CAN WE EXPECT IN 2023.
The overwhelming consensus amongst those who financially prognosticate is a difficult, choppy first 6 months and a better second half. The improvement assumes a collapse of inflation and increasing damage to company earnings creating higher unemployment caused by high interest rates. This allows Central Banks to start a reduction in rates, thereby cheering markets which rise in anticipation of better company earnings into 2024.
WHAT MATTERS
The central issue for how 2023 goes is not whether inflation come down hard, it will.
It’s not if rates will stop going up and later in the year start to reduce, both are likely.
It’s how do company earnings hold up. It’s ‘does the consumer have enough still saved or are willing to borrow and spend to keep company profits at least level until rates reduce’?.
Market PE ratios have come down this year from around 24 times earnings to 16ish which is slightly below the average. This means the post pandemic excess in valuations has been removed in the P (price). Valuations will therefore likely hold up in 2023 assuming the E’s (earnings) don’t drop next year.
22-THE INVERSION OF ALL
The figures below show how company share prices within each major sector of the US economy have performed over the last 10 years (CAGR is compound annual growth rate) and how they did in 2022.
The best performing sector over the last 10 years was semiconductors (computer chips). Progress in all significant sectors will be linked to advancements in microchips (Invidia, AMD, LAM Research etc) and in 2022, the sector fell 40%.
The worst sector, energy, which was up just 4% in 10 years, was the best performing, up 47% in ‘22.
Whilst there are good arguments for investing in oil and gas producers as we’re a long way from not needing carbon fuels and the companies are cheap on a P/E, it’s certainly not a growth sector with prices distorted by a war.
The price for both oil and gas which had major spikes higher, have more recently declined. The fall in the commodity price has not interestingly been mirrored in energy company stock prices, for which investors realised they had been overly punished at the height of the ESG awakening.
INVESTMENT THEMES FOR 23
The central question being asked is whether the era of low interest rates and low inflation is over. For those that believe so, this stops the outperformance of technology and heralds the long-awaited return of value investing.
This is not our view.
The speed of technological innovation is ever increasing. We are in the age of exponential growth in computing, AI robotics, battery technology, biotech etc.
Small companies will become huge in a decade and investor returns will be exceptional if they have exposure to the right companies in these mega growth areas.
- AI advancements this year have been astounding with ChatGPT and DALL-E 2 both becoming mainstream tools. I’ll write a separate blog to go into more detail but it’s well worth Googling these to read more.
- Deepmind launched AlphaFold 2 which can predict the shape of human proteins within cells with close to 100% accuracy. This has huge implications for Cancer research, antibiotic resistance etc.
- In Biotech scientists created an immunotherapy that cured a form of cancer in all patients. This is a first.
- In crypto, Ethereum switched from proof of work to proof of stake. This means the coin now offers a yield and is no longer energy intensive. If crypto is going to work this is the bridge. From a computer engineering perspective, the switch was achieved seamlessly whilst Ethereum continued to function. It was described in difficulty as the equivalent of changing the engines on a jumbo jet mid-flight.
- Scientists for the first time created nuclear fusion where the energy out exceeded the energy required to create the occurrence (energy net positive). Fusion is what the sun does. It’s the changing of the state of nuclei under intense heat and pressure. As the nuclei alter, the change creates a new nucleus with less mass. The lost mass is released as energy. In the case of the sun, it’s heat. Fusion is unlimited clean energy.
BUT IT’S NOT JUST TECHNOLOGY
We have the utmost respect for the best of the best companies. The companies that grow by 10%-15% per annum consistently and reinvest profits at the same level of returns year after year.
The importance of being able to create strong returns on capital invested and then reinvesting at the same return level is amazingly rewarding.
So, our themes are to have a mixture of the best fund managers to capture the best companies where exceptional growth is likely.
CONCLUSION
In thinking through all that’s happened post pandemic the core question is, what has it changed that won’t change back?
The pandemic certainly sped up existing trends like work from home, less business travel, biotech innovation etc. But has it permanently altered patterns only because of its occurrence? If not, then logically economies return to pre pandemic norms.
- Low Growth
- Low Inflation
- Mildly negative real Interest Rates
- Plenty of Central Bank liquidity pushing up asset prices but not inflation, as wage rises are muted.
If however, the economic trajectory has been reorientated then the future will be different.
- Higher Inflation (falls then rises then falls in waves)
- Employment tighter
- Higher Wage increases
- Tighter money supply
- Lower asset price growth
Lots of clever people are currently asserting both of the above as absolute. So, what do we do?
The good news is that it’s perfectly possible to make satisfactory returns on investments with either scenario being true. They’ll just come in different degrees from different places.
George, with a small amount of assistance from me (which he doesn’t think of as assistance!) has been rethinking the portfolios to be best able to capture the growth with either outcome.
He will be writing a report to explain his thoughts in detail.
In essence:
- We will be Increasing the fixed interest holdings as we can now invest with high-quality funds at a 5%-7% yield
- We want to invest more in funds targeting companies with consistent high Returns On Invested Capital Employed (ROCE) such as Fundsmith, Heriot and Smithson
- We know that growth will come with innovation and areas to invest are technology and healthcare. We do not think higher interest rates will prove a consistent headwind to returns as seen this year because they haven’t been previously and as inflation falls, rates stay stable and then reduce, this will reenergise these sectors.
It just leaves me as always to thank you for trusting us. We truly hate down years of returns, they are unavoidable but not insurmountable, and we know the portfolios are full of the best funds which will over time produce pleasing results.
And finally, a huge thank you to Nicola and George who are the engine room of LWM.
George has had a tough year personally but has not wavered from giving 100% commitment to his role. Nicola recovered at year end from an eye operation to severely burn her hands due to a faulty radiator valve and spent Boxing Day in A&E. She’s on the mend now but her typing speed has temporarily slowed down!
2022 has been a rough one but we are onwards and upwards!
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog, and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.