16th January 2023

After rising relentlessly throughout the year, headline rates of inflation in the UK and Europe finally dipped in November, although they remain cripplingly high.  We expect inflation to continue to subside in the months ahead but more important is where it settles in the medium term.  What began as inflation in prices of energy and manufactured goods has now clearly spread to services and to wages in particular.  Rising interest rates will take a toll on economic growth and rising unemployment may be the best way to curb inflation in wages.  We therefore expect the focus of attention amongst investors to shift from inflation to economic growth in 2023.  There are clear risks to the consensus that any recessions will be mild, that inflation has been conquered and that interest rates will soon be on the way down.

2022 was truly an ‘annus horribilis’ for investors in bond markets.  For more than a decade before, investors had enjoyed outsized returns from bonds as quantitative easing and negligible interest rates compressed bond yields to levels which became simply absurd.  The return with a vengeance of inflation has erased those past excess returns in the most brutal manner.  The big decision for investors now is whether they should be increasing their exposure to bonds.  Yields on offer are certainly much more attractive than they have been for years.  However, they are still significantly lower than where they averaged in the decade before the distortion of quantitative easing began in the wake of 2008’s financial crisis and when inflation was also much lower than it is now.  Although acknowledging that pockets of opportunity now exist, such as in high quality sterling corporate bonds, the Investment Committee do not yet think that the case for increasing our overall exposure to bonds is compelling.

Despite a spirited rally in the final quarter, global equity market indices ended the year down by just over 15% in local currency terms, making 2022 the worst year for stock markets since 2008.  The declines in stock markets last year were mainly due to falling share valuations as interest rates and bond yields rose.  In 2023 we expect corporate profits to become the main driver of share price performance.  Economic growth is measured in real (i.e. after inflation) terms so it is quite possible for corporate profits, which are reported in cash or nominal terms, to grow in a recession.  Control of wage inflation will be critical in protecting profit margins and companies with dominant market positions and strong balance sheets will be best placed to weather any forthcoming economic storm.  The Investment Committee continue to emphasise those characteristics in our fund selection in actively managed portfolios.