With (benchmarked) balanced portfolios having lost close to 15% in nominal terms and a further 10% in purchasing power due to inflation, 2022 proved a terrible year for investors. Some actively managed portfolios fared better, by staying away from the severely hit big tech names and keeping bond duration very low, but none managed to end the year in positive territory. There was simply no place to hide last year. Will 2023 be any better?
Looking back to the very start of 2022, inflation already stood at 5% in Europe and 7% in the US, well before the outbreak of the war in Ukraine and its devasting effect on energy and food prices. Years of printing money and (to the detriment of public debt) subsidising consumers that were unable to spend normally during the Covid crisis resulted in massive pent-up demand – which was unleashed from the second half of 2021 onwards.
In our January 2022 letter, we pointed to the record increase in producer prices, bound to sooner or later translate into higher consumption prices, and wondered yet again why central banks were neglecting this fact and continuing to consider inflation as only temporary. We also indicated that wages were at risk of increasing, which would anchor inflation into the system and make it hard to fight without serious interest rate hikes by monetary authorities. Hence our stance that longer duration bonds were to be avoided and that stocks were still the better choice, albeit with some put option protections.
In our February letter, we remained convinced that common sense would prevail in the Russian/Ukrainian dispute, with Russia, Ukraine, France and Germany trying to revive the 2014-2015 Minsk agreement that provided for a certain independency of the Eastern Ukrainian regions of Donetsk and Luhansk. This process failed, however, resulting in a full-fledged war between Russia and Ukraine. In that same letter, we also pointed to the difficult situation in the oil market, not seeing how OPEC+ countries would be able to increase their output (which they had thus far failed to do) after years of not investing in new production capacity. Given the very low level of world inventories, this could only result in higher oil prices in our opinion. We also mentioned that Covid was gaining pace in China, meaning potential further disruptions in the supply chain. And we still did not understand why the European Central Bank policy was neglecting the inflationary threat and keeping interest rates below zero.
In our March letter we expressed our disappointment (to say the least) at Russia having invaded Ukraine after all, causing additional supply chain disruptions and higher energy prices. Central banks did wake up though, abandoning their narrative of inflation just being a Covid-related temporary phenomenon, and bond markets began to trade downwards in anticipation of higher interest rates. Equity markets remained strong, as the only investment alternative to bonds, but we did warn that their valuations were lofty in historical terms, meaning that a serious correction could not be excluded.
In April, more than a month into the Ukrainian/Russian conflict, and with no end in sight, we wrote that Russia’s invasion of Ukraine was already posing serious challenges to the global economy. In terms of oil & gas market dynamics of course, but also supply – vital to some countries – of wheat and other grains. And the Covid resurgence in China only promised to add to inflationary pressures, by partially shutting down the consumer factory of the world. Worse, we thought, a scenario of stagflation could no longer be ruled out. For equity markets, however, we were convinced that the point of reckoning would come only when, or if, interest rates were to move up sharply.
A recession in Europe, and possibly also in the US (although its economy did look less vulnerable), would in turn weigh on company earnings. In our opinion, this risk was not priced in by equity markets, even though valuation multiples had already fallen from their highs. If we had one piece of advice on the equity front (beyond adjusting exposure out of Europe and into the less vulnerable US and Japanese markets), it was to abandon the “buy on dip” approach and rather start adopting a “sell on rally” strategy.
In our May letter, we reiterated once again that inflation was here to stay, as we saw “core” inflation gradually move up well above the central banks’ 2% target, which suggested to us that monetary policy in the US and Europe would remain on a tightening course. Although the European Central Bank (ECB) had not yet signalled an intention to raise its policy rate, the fact that Germany would be seriously upping its bond issuance even as the ECB reduced its asset purchase programme was a recipe for higher bond rates along the yield curve. Keeping bond duration short thus remained paramount in our opinion.
In our June letter we could only (and sadly) observe European core inflation reaching 3.8%. This being well above its target, the ECB would soon be forced to follow the Federal Reserve’s footsteps in hiking interest rates. The prior weeks had shown that even a moderate upmove in rates could inflict substantial damage on stock markets, the loss-making technology “darlings” being particularly impacted. Excluding the largest (profitable) companies, the high-tech sector had already lost half of its value – and some names even more. In essence, anxiety had made a comeback into financial markets. Whether it would turn into full-fledged fear would depend on how the situation was to evolve, from both a geopolitical and macroeconomic perspective. At that point in time, we opted to stick with the more optimistic view, albeit focusing on reasonably valued cash-generating companies and looking to add more option protections on a volatility pullback. But, on the other hand, were the war to keep raging and inflationary pressures intensify, central banks could become very aggressive. If private investor pockets then stayed closed, an economic recession would be inevitable and financial markets could undergo a severe correction.
In July, however, we remarked that the consumer was still present, spending as if there was no tomorrow. Supply-constrained travel infrastructures were under assault, particularly airlines and airports. The affluence at restaurants was such that serious prices hikes were being implemented – admittedly also to cover Ukraine-driven food inflation. The pent-up demand of the past two Covid-constrained years was unravelling fast, with spending having also shifted back from the online world to real “bricks-and-mortar” stores.
Still, this demand would come to an end at some point we thought – and abruptly so. The risk then would be that recent investments made into additional productive capacity would prove unnecessary. Order intakes could drop markedly, newly built factories remain empty and company finances take a double hit.
In August, we looked back at the July equity rally (a 7.8% gain in USD terms, 11% in EUR terms). This rally that was difficult to comprehend from a fundamental perspective, given the numerous issues the world faced, but probably simply reflected how cheap some financial assets had become after the disastrous performances of the first half of 2022. In our view, however, the July move was to be looked upon as merely an upside correction, and we urged investors to hold their horses.
In our September letter, we pointed to the high energy prices, which in turn meant persistent inflationary pressures, further monetary policy tightening and downward-trending company earnings: not a supportive combination for financial markets. Yet no big wave of retail selling had yet taken place, with many investors still operating on a “buy the dips” mode.
In an attempt to limit the blow on consumers, and the ensuing risk of social unrest, governments of heavily gas-dependent countries were busy setting up subsidy schemes. Unfortunately, reminiscent of the Covid cheques, these schemes tended to be of an indiscriminate nature, rather than focusing on those segments of the population that most needed the financial support. This was again, to the detriment of public debt, a free lunch for the consumers.
In such circumstances it was difficult not to expect financial markets to stay under pressure. The form of “salami crash” that we had been experiencing for quite a while would likely continue in our opinion, with an alternance of (sharp) daily drops and ensuing (lesser) daily rebounds. Selling equity market rallies still looked like the better strategy to us.
In our October letter, we warned of a possible “tipping point”. With central banks (finally) having taken the measure of the inflationary risk and signalling continued rates hikes until control of price indices be regained, nominal bonds yields were also moving up fast. Which was bringing them closer to the level at which investors could be tempted to make the “big switch” out of equities and back into fixed income, with a potentially large stock market selloff as a consequence. This has not yet occurred, but there will come a point when nominal yields are high enough to attract investors back into fixed income markets. The precise tipping level is obviously difficult to predict, and probably lower in Europe than in the US. Where would your tipping point stand? Think about it.
In November, we indicated that some areas of the fixed income market were certainly becoming compelling. And we were speaking not of US government bonds, whose (admittedly high) yields lose some of their attractiveness when factoring in the USD exchange rate risk. Nor did we consider European sovereigns, with the ECB behind the curve and the inflation situation particularly worrisome on our continent. No, it was European credit exposure we were looking at – albeit selectively and focusing on investment grade issuers with solid balance sheets.
Following the October and November equity market rally, we turned more cautious again, as indicated in our December letter, preferring to end 2022 and head into 2023 with option protections. A means of retaining upside exposure (against paying a premium), while limiting losses in the event of a renewed downtrend.
With the reopening of China, the local economy could gather steam over the next months, which would be welcome in a globally slowing (indeed soon recessionary) context. But if the Chinese economy does shift back to full speed during the next quarters, energy (oil and gas) prices are liable to trend up, going against the widespread investor anticipation of receding inflation – and thus of a central bank pivot. Indeed, we believe the market to be overly optimistic on this count, and not only because of the oil supply-demand outlook. Upward wage pressures are just starting to kick in, driven by food and energy prices of course, but also because of still severe labour shortages.
In our opinion, central banks will continue to hike interest rates (whatever it takes) until they are certain that inflation is back under control. Which unfortunately suggests that 2023 may again not be an easy year for investors, for a number of reasons.
We notably fear that the bulk of corporate profits will clearly disappoint still elevated analyst expectations, and that many newly established “growth companies” will go under due to lack of available capital.
Historically high government debt levels will also no longer allow new rounds of consumer subsidies; this spending bonanza, at the expense of future generations, seems definitively over now that the cost of debt has moved back into positive territory.
Restrictive central banks will be increasingly obliged to bow to financial market forces. It will not be possible for them to simultaneously hike interest rates and continue buying bonds to keep interest rates artificially low. Their balance sheets, incidentally, have already expanded to unprecedented levels because of the unrelenting printing of money in recent years and will have to be cut back. The losses that the various central banks are suffering on their bond portfolios already stand at historical highs (the Swiss National Bank reported a CHF 132 billion loss for 2022, six times higher than its worst loss on record in its 114-year history). There is thus a good chance that 2023 will see a gradual return to a more normal fixed income market, with appropriate risk premiums for the various issuers. This will certainly bring about bond opportunities for patient investors, but it also increases the likelihood of the “big shift”, away from stocks and back into bonds, that we have been talking about for some time now. The prospect of (likely) falling corporate profits in a climate of rising interest rates makes us fear that a second consecutive down year for equities market year is a distinct possibility in 2023. Of course, there will always be exceptions to the general trend – as was the case last year for oil and shipping stocks, well supporting the performance of our model portfolios.
All told, extreme caution and selectivity remain necessary and, barring a quick solution to the Russia/Ukraine conflict, 2023 looks like it will be another complicated year.
