Farewell to 2022 from the Investment Team

This time last year we were looking ahead to 2022 with much optimism that COVID-19 and the havoc it wreaked, would start to fade into the distant past. I don’t think any of us imagined that while our wish might come true, it would be superseded by war in Europe, political turmoil at home and historic pressure on the cost of living. Here is our investment team’s take on 2022…

Included in this update

Portfolio Performance – Holden & Partners’ portfolios have performed well relative to their benchmarks and competitors in an environment where there was little or nowhere to hide in deteriorating economic conditions.

Inflation & monetary policy – Inflation continues to dominate financial headlines across the globe.

Financial review – Financial performance differs across the world, and between sectors.

Sustainability – COP 27 was lack lustre on major issues as it was overshadowed by the energy crisis and immediate pressures for global leaders, but there are reasons to be optimistic about the mid-long term future of sustainable investments given developments such as the Inflation Reduction Act in the US.

Portfolio performance

To say 2022 has been a testing year would be a large understatement. With little to nowhere to hide, finding returns in a rising rate environment with deteriorating economic conditions has been tough. No single asset class has provided a positive return on the year, even the oil and gas sector, the only positive performer, giving back a lot of the success it was seeing at the beginning of the year.

This year has seen a very rare occurrence in investing. It is usually the case that equities and bonds are negatively correlated, meaning that when one goes up the other goes down. Modern portfolio theory is based on this. With all that we have seen this year; central banks raising rates, war in Ukraine, lockdowns in China, political upheaval in the UK – to name a few. This once relied upon relationship broke down and equities and bonds correlated positively. This has weighed negatively on portfolio performance.

Our portfolios have still performed well relative to their benchmarks and our competitors. The decisions we made at the beginning of the year to reduce the duration (the impact of interest rates on bond process) in our bond portfolio, introduce more value-focussed equity funds into the portfolio and continue with our exposure to infrastructure have all worked well at providing some ballast in these difficult times.

Work has already started on how we will set the asset allocation for next year.

Inflation & Monetary Policy

From our 2022 key themes, you may remember our hard stance on the ostensible ‘transitory inflation’, and that was prior to a European war which would have major implications on global supply chains. Whilst we would not have predicted inflation above 10%, adjusting our portfolios for a higher sustained level of inflation at the beginning of the year by reducing duration and increasing exposure to alternatives with inflation linked returns has been key to dampening losses.

Spiralling prices have largely been attributed to supply chain issues and stable demand. Supply chain bottlenecks resulting from lingering COVID-19 logistical disruptions and production delays were already a concern for global growth prior to the Russian invasion of Ukraine in February. The resulting sanctions on Russian exports, notably on Russian oil and gas, sparked major concerns over global energy supplies and future security. Energy commodity prices soared, which had greater inflationary ramifications as they increase the cost to produce other goods and provide other services. Furthermore, increased prices and reduced supply of base supplies in the agricultural sector such as fertiliser and grains were compounded by summer droughts and increased cost of transportation.¹

It is clear to see that inflation is not being driven by demand, which is why the actions of central banks has divided opinions. Successive and significant interest rate rises is a tried and tested monetary response to rising inflation, however increasing borrowing costs does little to reduce prices when demand isn’t driving the increases. As inflation persists above wage growth and retreating commodity prices, government authorities are turning to schemes such as windfall taxation to combat inflation driven by corporate profiteering,² at a time when corporate profits have surged to record highs.³

Financial Review

UK blue-chip stocks performed resiliently in one of the most volatile years in history. Aided by the commodity and defensive nature of the index, the FTSE 100 has finished the year flat. The same can’t be said however for the more domestically focused FTSE 250 which at this juncture of the year is down 19%. It indicates investors’ weak appetite to invest in UK companies affected by the European energy crisis and labour shortages stemming from both Brexit and COVID-19 related outcomes like long-term sickness and early retirement.

The self-assured hubris among US equity investors was shaken in 2022 as central bank policy forced investors into risk-off corners of the market. From peak to trough, the US equity market fared worse than European and Asian counterparts due to interest rate differentials pushing the US dollar higher thus becoming a headwind for US multinationals and earnings growth. Despite the overwhelming equity and bond weakness, on a fund level, flows into US exchange-traded funds (ETFs) have reached approximately a positive $550 billion at this point of 2022, the second-most calendar-year inflows on record.⁴ This highlights investors’ future optimism for US markets and reaffirms investors’ appetite for cheap and easy-to-trade products.

Europe

In a year where Russia’s barbaric invasion of Ukraine triggered the worst security crisis in Europe since World War II, it is no surprise that European equity markets have taken a hit. The consequential sanctions on Russia forced Putin to reduce energy flows to Europe, exacerbating the imbalance between supply and demand thus pushing inflation to record highs. Furthermore, predictions of a deep recession because of the energy crisis have also put downward pressure on European assets this year as investors look forward to 2023.

Asia/EM

Investors seeking respite from volatile European and US markets didn’t find it in Emerging Market equities where the benchmark MSCI Emerging Markets Index lost 40% since its peak in 2021.⁵ A large drag on this performance was China, which was dealing with a fragile property sector and a COVID-19 drag which restricted economic momentum. Furthermore, many emerging market currencies depreciated against a strong US dollar in 2022, increasing import prices and further stoking food and energy price inflation in commodity-importing countries like Sri Lanka and Pakistan.⁶

Fixed Income

The combination of high inflation and rapidly rising interest rates made 2022 a difficult year for fixed income investors. Double digit losses were made across broad global fixed income indices, with investors forced to reach further down the credit rating scale to reduce losses or take as little duration as possible to shield portfolios as markets continually adjusted interest rate forecasts higher. The final quarter of 2022 brought a small reprieve to bond holders, as inflation prints in the US and UK came in under market expectations, and Federal Reserve Chair Jerome Powell hinted that easing financial conditions may already be underway.

Alternatives

At Holden & Partners, we believe that sustainable businesses will deliver alpha (returns above the broader market or index) over the medium and long term. This is reflected in our sectoral allocation, with limited exposure to oil and gas sectors compared to conventional benchmarks. As the best performing global sector year-to-date, our exposure to rising energy prices was achieved through our allocation to renewable energy infrastructure funds. The Renewable Infrastructure Group was the best performing fund in the Model Portfolio Service, with inflation linked revenues and limited exposure to rising costs of production. Despite a headwind from the Truss administration in the form of a windfall tax upon renewable energy providers,⁷ the fund has benefitted from a mixture of revenues linked to inflation indices (indexed) or wholesale market prices. This approach has allowed for participation in rising energy prices through assets that have long term sustainable investment drivers.

The Inflation Reduction Act, signed into law in August, is an unprecedented commitment to tackling climate change from the world’s largest economy.⁸ The colossal $369 billion provision for funding climate initiatives touches almost every aspect of US emissions, and therefore has significant tailwinds for many companies held by our sustainable managers. The investment and efficiencies created from the subsidisation will have global outreach, and the act is not a short-term boost for the sector, but potentially underpins the next decade of sustainable growth.

Over the past three years, we have significantly reduced our property exposure in our model portfolios. Going into 2022, we held the minimum exposure to our remaining property holding (TR Property Investment Trust). The holding suffered as rising interest rates increased debt costs for often highly leveraged real estate companies. The trust has seen the net asset value discount, which reflects negative sentiment rather than declining asset prices, widen significantly. Property share prices are far more volatile than underlying physical transaction markets, and whilst the underperformance can largely be attributed to declining asset prices, the negative sentiment driving the widening discount can sharply revert if market sentiment shifts.

Sustainability

Last year’s sustainability review spoke of an ‘unparalleled number of climate events and anomalies’ and unfortunately 2022 gave us more of the same. Extreme flooding in Pakistan killed over 1,700 people and 1.2 million livestock, with relief still needed.⁹ Rampant wildfires across Europe burned an area of 700,000 hectares – an area roughly the same size Azerbaijan.¹⁰ At home, the temperature in the UK breached 40ºC for the first time, with a series of fires breaking out across the country. With these events becoming increasingly more regular, it is crucial that action and policy push in the right direction.

Inflation Reduction Act

In the US the Inflation Reduction Act was signed into law over the summer, representing the most significant legislation in the country’s history aimed at boosting clean energy investment and cutting greenhouse gas emissions by about 40 percent below 2005 levels in 2030.¹¹ Our Q3 round up gives a very brief overview of this.

COP 27

The underwhelming feel of COP 27 was perhaps as a result of the energy crisis affecting key players. European countries for instance, have upped their consumption of coal as they look to replace Russian energy.¹² A positive development from the conference was the establishment of a Loss and Damage Fund, a pooled fund designed to support countries most affected by climate change.

Regulation

The FCA released their consultation paper on Sustainability Disclosure Requirements (SDR), proposing a package of measures aimed at clamping down on greenwashing.¹³ One of the proposals include the introduction of a labelling system to help retail investors navigate the market for sustainable investment products. The 3 labels introduced are: ‘Sustainable Focus’, ‘Sustainable Improvers’, and ‘Sustainable Impact’, with those failing to meet the criteria being given no sustainable label. While the labelling criteria should go some way to reduce greenwashing, it will certainly be interesting to see how this affects investment flows.