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Monthly Monitor - November 2022
In the short term, there are a couple of factors at play. Firstly, 2022 is turning out to be the year in which inflation returns and it is deflating the bubbles that had built up in financial markets over the last decade. Secondly, 2022 has been a year of negative surprises, of which the war in Ukraine and its impact on energy prices is one, and the continued COVID shutdown in China is another.
These negative surprises along with the return of tighter monetary policy and higher inflation have created a wall of worry which is weighing down equity markets. The question is, can equities climb this wall of worry?
As well as dealing with this question, equity investors must look through these short-term issues and consider the fact that the next economic cycle will be more inflationary than the last. This has ramifications as to which parts of the equity market will perform.
To attempt to answer the question – “Is it time to buy equities?” – we break the question into three parts.
Firstly, how to navigate the bursting of the bubbles? Secondly, whether equities can climb the wall of worry? Thirdly, is now the time to position for the next cycle?
The prolonged period of low inflation and low interest rates that has existed for over a decade saw valuations rise in long-duration assets such as growth equities and long-dated fixed-interest bonds. The COVID pandemic saw these valuations rise yet further.
This crescendo was evident in the astronomical rises in assets such as Crypto and Special Purpose Acquisition Companies (SPAC’s) – remember them – and the spectacular performance of unprofitable companies and mega-cap growth stocks that occurred through the COVID pandemic.
Whilst we didn’t foresee the crescendo in the bubbles that occurred, we have been convinced for a long time that these bubbles would burst when inflation returned. The bubbles are now bursting. The SPAC phenomenon is over, Bitcoin is down over 60% this year and mega-cap tech stocks such as Amazon, Tesla, Google are down over 40%, whilst Meta (formally Facebook) is down over 70%.
So, how should investors react?
The first point to make is that the sell-off that is occurring is rational and welcome. There was an inevitability that the frenzied speculation would end in tears as investing had moved away from fundamentals.
In this respect, what is playing out now is similar to the 1999/2000 TMT collapse. Value investors didn’t suffer in the 12 months that followed the TMT collapse and are not at the epicentre of today’s sell off either.
Performance of value and growth styles: Mar 2000 to Mar 2001
Source: Refinitiv Datastream, 9 November 2022
Performance of value and growth styles: Nov 2021 – Nov 2022
Source: Refinitiv Datastream, 9 November 2022
2022 has seen one of the great de-ratings occur within equity markets. We wrote about this in our July monthly monitor – “Uncertainty has caused the third greatest derating of equities”. We wrote this piece after increasing the equity weighting across our multi-asset portfolios.
We believed that equity markets had the potential to climb the wall of worry that built up during the first half of the year. The wall is staring to crumble.
Whilst the Ukrainian/Russian war continues, it has resulted in an energy shortage across Europe and natural gas prices are falling. Secondly, there are signs that China is finally preparing to reopen its economy post COVID. Thirdly, signs are emerging that inflation is easing.
These are factors that have the potential to cause a year-end rally in equity markets. We believe such a rally would be led by cyclical sectors such as Industrials, Materials, Financials and Energy whilst defensive sectors such as Consumer Staples, Healthcare, Utilities and Telecoms may struggle.
The relative valuation of the cyclical sectors relative to the defensive sectors is at its lowest level in over forty years. Our equity funds are overweight these cyclical sectors.
Perhaps the biggest question equity investors are facing, is what type of equities to own long term.
2022 is proving to be a transition year from a cycle which was characterised by low inflation and low interest rates into one which we believe will be characterised by higher levels of inflation, higher levels of nominal growth and higher levels of interest rates.
As we detailed on our last webinar “2022 transition year”, we believe the next cycle will see a return to investing in the real economy. This will result in sector leadership within the equity market changing back towards value sectors.
Below is a list of themes and sectors we expect to come to the fore through this cycle.
Investing in the equity market always carries risks and rewards, today is no different.
Our approach can be summarised as follows. We continue to avoid the technology bubble that is deflating, and whilst this area of the market may have short-term rallies, we don’t believe it will be one of the outperforming sectors through the next cycle so see no reason to get involved now. We think the conditions are in place for equities to climb the wall of worry into the end of the year and our funds should benefit from that, particularly if the rally is led by cyclical sectors. Most importantly though, our focus remains on the long term. We believe now is the right time to invest in undervalued securities that have the potential to prosper through the forthcoming cycle.
Any views and opinions are those of the Fund Managers, and coverage of any assets held must be taken in context of the constitution of the fund and in no way reflect an investment recommendation.
Capital at risk. If you invest in any Gresham House funds, you may lose some or all of the money you invest. The value of your investment may go down as well as up. This investment may be affected by changes in currency exchange rates. Past performance is not necessarily a guide to future performance.
The above disclaimer and limitations of liability are applicable to the fullest extent permitted by law, whether in Contract, Statute, Tort (including without limitation, negligence) or otherwise.
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