This year has been a painful one for many asset classes. Fixed income markets have disappointed and equity markets been under significant pressure. Within the latter medium and smaller sized companies have struggled most, in the UK the underperformance versus large caps is the widest it has ever been in any previous recession in the last 50 years. Furthermore, we have seen sectors such as energy strongly outperform and companies with strong growth drivers lag, mainly because with higher interest rates the market has deemed that their future profit streams should be valued lower.
The portfolios have been continually retested with respect to investment views and positioning. Yet, it is incredibly important at times like these to try and remain emotionless and not make changes to favour investments which have just performed well and ditch those that have not; the latter are likely already discounting a lot of bad news and the former good and to make irrational and reactionary changes is unlikely to benefit the portfolios.
The fixed income positioning has worked well, as portfolios already had limited government debt exposure and were positioned with a reduced sensitivity to higher bond yields and therefore falling bond prices. The portfolio manager is very alive to the opportunities that higher yields now present, but with inflation still raging, interest rates rising and a recession looming we haven’t yet increased risk at the asset allocation level. However, as we would expect, some of the underlying fund managers have started to do so.
In fact, the fixed income exposure was recently reduced in favour of alternative investments. Whilst fixed income yields do look much more attractive now there is a clear risk that inflation does not fall back to the levels that central banks and markets are anticipating, or even fall as quickly as is hoped; especially if wage pressures continue to build. Diversification has been increased and included exposure to funds that are designed to provide returns that are not overly reliant upon or correlated with mainstream markets (fixed income and equities).
Many of our equity funds have fallen in value this year. This has, generally, been due to their bias to high quality, growing and/or medium and smaller companies. The investment committee define quality companies as being those with strong balance sheets (limited debt), reliable revenue streams and that are growing. This has not always worked this year, as the market has priced in higher interest rates, thereby reducing valuations and, for medium and smaller companies, a recession; these tend to be more exposed to economic cycles than larger businesses. The investment committee believe it is absolutely right to remain biased to these areas. Quality and growing companies are where you want to be tilted to in a recession and not more cyclical businesses (e.g. banks and energy) which are very vulnerable to falling demand. Although, to be clear, the portfolios are still diversified with investments in most sectors. Quality companies also tend to outperform over the longer term, because they continually deliver good results and are not as exposed to fickle consumer demand. In fact, exposure to quality companies has increased in the portfolios through the inclusion of a new fund, which has a large weighting in companies selling products that are deemed necessities and not luxuries, such as Johnson & Johnson and Microsoft. The investment committee have faith, and history is firmly on their side, that medium and smaller companies will outperform larger ones over the long term. This is because they are generally more nimble and grow faster but have fallen hard as the economic situation deteriorates. A lot of bad news is now priced in, and this is potentially an exciting time to be investing in them, albeit it will be bumpy, and patience is needed.
The investments are constantly reviewed but we are increasingly excited that the market movements, that are starting to materialise, bode well for future returns from here, although again there will be tough times to come. This has already started to be reflected in long term capital market assumptions across the industry, for example JP Morgan’s developed market equity forecast has risen 3.4% to 7.8% p.a. (in local currency terms). The investment committee believe we are positioned well for risks, for example, high and sustained inflation and recession, but also opportunities, as quality reasserts itself and medium and smaller companies return to favour.