News & Insight • Market Insights

03 January 2023 | William Buckhurst

2022 A Year in Review

2022 was a difficult year for investors.  Inflation far exceeded almost any meaningful estimates made at the start of the year, as did central bankers’ policy response. 

On January 1^st, interest rate expectations in the US for the twelve months ahead (the so called “Fed Funds Futures Rate”) sat at around 0.82%; that forecast is now 4.3% and the Federal Reserve now estimates that the central rate will not be lowered until the end of this year, or early next year, at the very earliest.  It was a similar story in other developed economies, with our own UK central bank rate now at 3.5% and set to go higher as inflation remains at elevated, albeit slightly falling, levels.  Arguably the UK market suffered a more volatile period for interest rates following the short-lived and ill-thought-out policies put forward by Prime Minister Truss and Chancellor Kwarteng; however, some stability has now been restored by their successors and it is good to see the beleaguered UK mortgage holder gaining some respite from marginally lower rates as the year ended.

The market response to higher inflation was on the one hand predictable, on the other hand not.  As could be expected, broad equity markets fell as did conventional bonds. The MSCI World Index fell by 16% in local currency terms although this was mitigated somewhat for UK investors by the strength in the US dollar.  And global bond indices fell by a similar amount, probably the worst year for fixed interest investors since 1994, perhaps longer.  Moreover, this was the first year that equities and bonds have both fallen by more than 10% since accurate records begun over 150 years ago.  It was undoubtedly a disastrous year for the traditional 60/40 (60% equities: 40% bonds) investor.

Less easy to predict was that index-linked bonds fell sharply (it turns out that because they tend to be longer-dated they carry more “duration” risk than they do short-term inflation protection) and gold fell (in spite of higher inflation and geopolitical unrest, precious metals do not like a strong US dollar along with negative real rates).  High quality, cash generative technology and other growth companies (such as Microsoft, Alphabet and Nike) also fell because, despite selling products and services where there is still strong demand, they were expensively priced in the first place and so a de-rating tends to occur when the market figures that a higher risk-free rate will reduce the present value of their future earnings.

Meanwhile, areas once shunned by ESG investors such as oil and gas, mining, and large pharmaceutical companies, (eg Royal Dutch Shell, Rio Tinto and Merck) performed well.  Portfolios that were underweight these areas would have underperformed markedly and 2022 may well turn out to be the year when the investment community started to look under the hood and start re-evaluating the $40trillion ESG market.

One of the more familiar outcomes of 2022 was that in times of market stress the US dollar tends to catch a bid.  So, in a year of improbable outcomes, there was a certain reassurance in the fact that the link between “risk-off” and a strong dollar remained unbroken.  Another explanation is interest rate differentials. Higher US rates attract money from abroad, lured in by the spruced-up yields. 2.7% on a two-year German Bund is all right, but 4.4% on a two-year US Treasury sounds a whole lot better.  So, money flows out of lower-yielding currencies and into the higher-yielding US, pushing up the dollar in the process.

It is now obvious as we end the year that soaring demand and a lack of supply thanks to bottlenecks caused by the pandemic was always going to lead to more persistent price rises across a broad swathe of goods and services.  What was less easy to predict was that this was going to be exasperated by the tragic war in Ukraine which heightened food insecurity and triggered a surge in fuel and energy prices.  The annual inflation rate hit 8.6% in the US and 11.1% here in the UK, at or around 40-year highs but, as things stand today, now show signs of abating and should continue to fall through 2023.  Either way, western governments face a once in a generation cost of living crisis for which they appear to have few solutions.  The central bankers’ response has been to slow or stop asset purchase schemes and hike interest rates faster than many had expected.  The much awaited “pivot” remains and as we finish the year central bankers have certainly slowed the pace of hikes; nonetheless, their rhetoric remains hawkish. It was left to Christine Lagarde of the European Central Bank to put the doves back in their cote (or Colombier):

“Anybody who thinks that this is a pivot for the ECB is wrong,” she said at her last news conference just before Christmas.

This year was not just about higher rates though.  For decades the words “China” and “growth” were synonymous.  However, an unprecedented confluence of events in 2022 conspired to trigger China’s slowest growth rate in years.  

The primary reason for this was President Xi’s zero-covid policy which, as the rest of the world re-opened, saw hundreds of millions of people still in mandatory lockdowns, leading to food and medicine shortages and a stifling of economic activity.  Many Chinese workers were stuck at home during the worst of the lockdowns, while authorities frequently shifted factory closures from even a single nearby case, which continued to cause production slowdowns and disrupt global supply chains.

Second, was an increasingly authoritarian government’s crackdown on the private sector. President Xi’s “Common prosperity” goal, introduced in mid-2021, aims to redistribute more of China’s wealth from the rich to the poor and has had the effect of imposing tougher love on, amongst others, China’s fast growing technology sector.  Internet giants Alibaba and Tencent finished the year down 25% and 24% respectively. 

China’s real estate sector also continued to struggle after years of over exuberance (aka leverage), encapsulated by the default of prominent developer Evergrande.  This has serious implications given that the property sector in China accounts for almost a third of GDP and it is estimated that 70% of household wealth in China is stored in property.

Finally, a severe heatwave, followed by a drought, hit the south-western province of Sichuan and the city of Chongqing in the central belt in August. As the demand for air conditioning spiked, it overwhelmed the electricity grid in a region that almost entirely relies on hydropower. Factories, including major manufacturers like iPhone maker Foxconn and Tesla, were forced to cut hours or shut altogether.

Fitch has now lowered its 2022 and 2023 GDP forecasts for China to 2.8%, from 3.7%, and to 4.5%, from 5.3%, a far cry from the 8.1% that the Chinese government put their annual GDP growth at in 2021.  The much touted “China century” is hitting its first major speed bump.  Nonetheless, a recent relaxation of President Xi’s Covid policies combined with more monetary stimulus from the State Council, including a cut to domestic banks’ Reserve Ratio Requirement (RRR), have seen Chinese equities rebound from their cheapest level in decades to finish the year down 21% but up 33% from their lows. 

Meanwhile, India, already the fastest-growing economy in the world, having clocked 5.5% average GDP growth over the past decade, continues to race ahead.  Three mega trends - global offshoring, digitalization and energy transition - have set the scene for unprecedented economic growth in the country of more than one billion people. In stark contrast to China, Indian equities finished the year up 2% and on around 23x forward earnings now trade at their most expensive level in decades.

Inflation was notably absent In Japan for most of 2022. The Nikkei has fared much better than US or European benchmarks this year, returning -9% in local currency terms, thanks in part to cheaper valuations at the outset and the impact of a weaker yen boosting the profits of exporters. Under yield curve control (YCC), the Bank of Japan had set a -0.1% target for short-term interest rates and caps the 10-year bond yield around 0.25% as part of efforts to achieve its 2% inflation target.  But with inflation creeping up, the Bank of Japan surprised many just before Christmas by adjusting the target up to +/- 0.5% prompting a spike in bond yields and a very real chance that local pension funds will need to sell JGB’s and perhaps buy Japanese equities. Equally, Japanese institutions and individuals have very large overseas asset holdings and will likely repatriate some as the Yen appears to have bottomed and hedging costs rise.  Either way, there remains a significant opportunity for foreign investors targeting a market that was already cheap and has many companies awash with cash on their balance sheets.  Activist shareholders in Japan remain alert to the opportunity.

Higher interest rates in the West combined with slower growth in China have conspired to create possibly the most widely anticipated global recession ever.  Perhaps we are in that recession already, perhaps it is still ahead of us (we won’t know for sure until the backward looking, technical definition of two consecutive quarters of negative growth occurs).  But as clear as winter was coming, a recession was being widely heralded by almost all market participants from the spring / summer of 2022 onwards and so, arguably, markets have already factored a lot of this in.   The reality is that economic data over the last year has actually not been that bad.  Unemployment rates remain very low (albeit skewed by the fall in the participation rate) and business surveys on areas such as new orders, inventory levels and supplier deliveries have fallen but remain in positive territory in many parts of the world – the US ISM Manufacturing survey did not fall below 50 (which signals a contraction in activity) until November.  It has been in expansion territory since the pandemic.  The more important Services (non-Manufacturing) PMI has remained in expansion mode all year and even went up a bit in November.

Admittedly, consumer confidence surveys have been a lot weaker but – due in part to the fickle nature of human emotion – can be volatile, often bouncing as quickly as they fall.  Nevertheless, with annual inflation data in high single digits, higher interest rates, and Covid-related household savings dwindling fast, we face an unprecedented cost of living crisis and consumers are unlikely to come to the rescue of the global economy any time soon.

It’s been a very difficult twelve months.  Both equities and bonds have corrected, while gold has made little progress and index-linked gilts have failed to protect, which means that UK investors have had almost no place to hide, apart from short-dated US Treasuries / cash and the once shunned resources sector.  Even well diversified portfolios have taken a hit, albeit only giving back some of the returns of the previous decade.  Looking ahead the next twelve months look different.  US triple B corporate bonds started the year yielding just 2.5% and now yield a more appetising 5.8%. Global equities started the year on 22x forward earnings and have now fallen to around 16x.  US Treasury yields relative to expected inflation have gone from around -1% to +1.5%.  Going forward developed market growth will decelerate while growth in China should pick up as Covid restrictions fall away.  So, broadly speaking, the last twelve months has been a healthy re-set from some of the extended valuations that arose post-Covid.  A portfolio balanced across different equity styles and asset classes continues to make sense while exposure to what are now less fashionable growth areas should provide a meaningful pay-back over the medium-to-longer term.