22 May 2022
In the early weeks of 2022, weak sentiment in global equity markets was driven primarily by investor concern over central banks tightening monetary policy, which would increase the cost of borrowing and therefore put pressure on asset valuations. In other words, this was mainly a pricing effect rather than a reflection of pessimism about company earnings.
More recently, and exacerbated by the economic and financial impact of the war in Ukraine, these concerns have shifted towards a fear that inflationary pressures are pushing the global economy towards a slowdown and potentially a recession in some major economies. Declining consumer demand and rising costs both have negative implications for corporate earnings. In addition, China’s Covid lockdown policies are also acting as a headwind to growth and damaging market sentiment in the industrial sector. These factors are impacting earnings data, which is in turn causing volatility in markets, although they do not necessarily indicate that we are heading into a global recession.
Where might the markets go from here?
Having fallen significantly since the beginning of the year, the major equity markets are no longer looking expensive. In the US markets, which dominate global investment, the S&P500 and the tech-heavy Nasdaq indices are both trading at or just below their 10-year average price to earnings ratios (source: Bloomberg 23 May 2022).
We do, however, expect equity markets to remain challenging for the next few months in response to worsening macro-economic data. For this to improve, we need to see an easing-off in the inflation data, and indications that the economic growth outlook is stabilising rather than deteriorating. Neither of these is likely to happen until later in the year.
We still expect inflation to begin to fall back before the end of 2022, as the year-on-year rate of price increases should start to decline once we pass the anniversary of the initial sharp spike in energy prices which occurred in the autumn of 2021. However, the extent to which the market may fall further from here will depend principally upon whether or not the global economy avoids recession.
Portfolio update
Consistent with our aim to deliver strong long term returns from diversified portfolios, in CCLA’s multi-asset funds, we maintain our focus on global equity markets. We remain alert to changing market conditions and to protect our clients portfolios we have been making incremental changes:
- Towards the end of 2021, we reduced our exposure to what we deemed to be overpriced equity markets by raising the amount of cash
- In March 2022, as the market largely recovered from the downturn that had followed February’s outbreak of war in Ukraine, we further raised cash from the equity portfolio and added to our alternatives exposure where we are seeing genuine inflation protection and diversification.
- We continue to avoid the bond markets, on the basis that inflation and rising interest rates are inherently damaging to returns from fixed income assets.
Cyclical industries such as the traditional energy (oil) sector do not have the quality and growth characteristics that we seek, as demand is highly correlated with global macro-economic conditions. Within the equity book we generally have less ‘cyclical exposure’ than the market itself, meaning that our portfolios’ returns are not closely linked to the changing fortunes of the wider economy. Instead, we remain focussed on quality companies, with stable and growing cash flows, at attractive valuations. We tend to avoid the energy and commodities sectors altogether and are considerably underweight banks and industry groups like mining, autos, supermarkets and other economically sensitive sectors.
In the calendar year to date, our positioning has moved further towards a defensive stance. We have reduced holdings in consumer discretionary businesses such as Adidas, recognising the pressure on consumers’ real disposable income that results from higher inflation. We have further trimmed the portfolio’s exposure to banking, a sector which is vulnerable to slowing economic growth.
We have redeployed some cash by adding to a handful of positions where we see more defensive properties, such as selected consumer staples and technology businesses.
Reflecting our wariness of the outlook for markets, we are still holding cash balances which are high relative to the norm for our multi-asset portfolios, and we remain cautious in reinvesting this, seeking to apply it only where we see a clear opportunity to add value by acquiring high quality assets at attractive prices.
Performance update
Our philosophical preference for quality and secular growth positions us in stocks that:
- are less economically sensitive
- have less exposure to the damaging effects on margins of high and persistent inflation.
The characteristics of our equity portfolios confirm that these stocks have superior profitability indicators (margins, returns, leverage etc) with superior growth credentials (sales and earnings growth).
The market’s recent response to the prospect of tighter monetary policy has been most marked in the valuation of growth stocks. This is because for these stocks, today’s prices depend significantly on future earnings, and a higher interest rate environment means that these earnings are steeply discounted back to arrive at today’s value. Our bias towards quality growth has therefore had a detrimental effect on relative returns over the calendar year to date. The most significant factor has been because we do not invest in the traditional energy sector which has fared strikingly well over the year to date, because companies in that sector do not have the qualities that we seek for our portfolios.
Looking ahead, as the dominant influence on market pricing shifts from tightening monetary policy towards an assessment of companies’ earnings prospects at a time of lower economic growth, we would expect the relative performance of our equity portfolios to improve as a result of our focus on quality.
Elsewhere in the multi-asset portfolios, a high proportion of our holdings in alternative assets are well placed to contribute positively to returns, even at times when inflation is elevated, and economic growth is weak.
Income
Income distributions to fund unit holders, supported by the underlying free cash flow attributable to our funds’ portfolios, are not directly affected by volatility in capital values and are expected to continue as previously forecast.