mid-year investment outlook
mid-year investment outlook
The value of investments can go down as well as up, your capital is a risk.
PORTFOLIO CHANGES
our outlook
esg mandate
looking ahead
2022 has developed into a year of challenges. We’ve experienced three difficult dynamics evolve for investments so far in 2022. First, the withdrawal of fiscal and monetary stimulus which is slowing economic momentum. Second, central banks stepping up their rhetoric and the pace of interest rate increases. Third, the invasion of Ukraine and China’s zero-Covid policy have created supply shocks and additional inflation.
In this report our Asset Management team has a look at how some of these dynamics could be changing from here.
Mohammad Syed, Head of Asset Management
Portfolios braceD ahead of projected slowing economy
In expectation of the challenges we would likely face this year, we scaled back equity investments at the end of 2021, selling European shares and reducing exposure to small and medium sized companies. Portfolios didn’t have a large exposure to the high-risk technology sector which suffered large falls this year as we had considered these as overvalued for some time.
Over the last few months, we continued to make numerous changes to our investments, such as scaling back further low capitalisation companies and growth sectors which can be higher risk. We increased our UK equity holdings meaning we added to ‘value’ stock holdings such as finance and healthcare. In fixed income we continued our preference for thematic credit funds.
WHAT'S OUR OUTLOOK?
The three dynamics of lower stimulus, rising rates and Ukraine will continue to be dominant themes, but there are also some changing dynamics.
Global inflation has dominated the investment narrative so far this year. However, it seems inflation momentum is starting to slow in some countries, most importantly in the US, as supply-chain bottlenecks ease and year-on-year inflation reports start to slow.
One potential bright spot in the next 12 months could be that a reversal of inflation means a more optimistic consumer, especially in the US as real earnings growth might rise. It would also give the US Federal Reserve (the Fed) more flexibility. Altogether that would be a clearly better narrative as we approach the end of the year. However, the cost of living crisis is real and we are well aware that this poses the risk of an economic slowdown in H2.
The UK outlook differs from the US due to expectations of higher inflation this side of the Atlantic, fuelled in part by rising wage expectations, tax increases and post-Brexit economic dynamics.
The initial take away of Boris Johnson’s resignation is perhaps that any successor may choose to loosen fiscal policy and implement tax cuts. Which could then impact the UK inflation outlook and BoE rate decisions, this will become clearer once a successor has been chosen. The impact for global markets and diversified portfolios is however limited.
Overall, further stimulus mix may add to inflation and is problematic for UK assets although less for our UK equity exposure which is now mostly in large global companies following our reduced exposure to domestic, smaller companies. In fixed income the gilt holdings in portfolios will be replaced with a diversified basket of G7 bonds – which still does include some gilts – this summer.
We’ve seen some major shifts in markets. The yield on the US Aggregate bond index has risen the 12 months to June to 3.58% – meaning prices fell – while global equities have seen a material change towards lower valuations.
Forward earning valuations are falling compared to previous figures – which could have been considered overvaluations (US stocks are now at 17x earnings, down from 21x). This reflects the inflation and rising bond yields in recent months. Similarly, credit assets are discounting more pessimism.
In the current environment, we believe quality companies with a long-term earnings potential will continue to perform relatively better. Healthcare remains the most convincing sector to us.
We acknowledge that data changes rapidly but so far our research, which is based on several economic and market indicators, suggests the probability of a severe recession is still low and that US consumers and businesses are in good shape. Although, persistent inflation, leading to higher interest rates, would increase the recession risk as the Fed is eager to restore price stability as quickly as possible in order to keep inflation expectations from running away.
The UK is harder to predict as higher energy costs, taxes and Brexit make for a difficult mix. The Bank of England is alert to economic risks and seems willing to accept higher inflation for now, but this may change. There is a risk that wage inflation will accelerate in the coming quarters and drive inflation expectations higher. The recent fiscal support to combat climbing energy bills may do little to ease the cost of living before Q4 and we could see an increase in union action, demanding double-digit pay increases in the face of double-digit inflation.
Central banks such as the Bank of England and the Fed manage interest rates and are well aware of how “over hiking” may bring recession and how “under hiking” may leave inflation unchecked. This doesn’t mean they will abandon rate hikes, but they will remain very sensitive around pushing markets and economies too far. Even if we do see short-term volatility as central banks and markets react to each other, a long-term perspective is key.
The best-case scenario from here would be no additional rate increase guidance as inflation moderates, limiting risks to global growth. Changes to China’s zero-Covid policy and a more positive geopolitical situation in Europe would be additional positive drivers.
The worst case is a recession. This could come following a sharp decrease in the pandemic financial stimulus leading to a contraction in growth. Inflation proves stickier which makes it harder for central banks to stop rising rates. Tighter Covid restrictions in China and more negative geopolitical developments in Europe would also be drivers.
The three dynamics of lower stimulus, rising rates and Ukraine will continue to be dominant themes, but there are also some changing dynamics.
Economic Growth
In 2020-21 our in-house analysis recorded a steep rise in economic activity driven by the large monetary and fiscal Covid stimulus. This momentum started to roll over at the end of last year indicating a still expanding, though weakening, trend for economic growth.
The below chart is our Leading Indicator for Global Growth (LIGG), which gauges the direction and magnitude of growth for the global economy. As of mid-June our LIGG indicates a slowing economic momentum.
Leading indicator for Global Growth
Source: Coutts
IN SUMMARY
With major markets having experienced double-digit declines and asset valuations having corrected significantly, many risks are now discounted. But we expect continued economic uncertainty. Markets are prone to over-react in the short term and through the many drivers (central bank policy, inflation, growth momentum and Ukraine) we see volatility as persisting. A rapid end to the war in Ukraine would be a very positive development although, sadly, it looks unlikely at the moment. Central banks changing their guidance and reducing rate hike expectations would equally be very supportive for asset prices, but this seems premature at the moment.
Considering all these dynamics and potential surprises they hold, we plan to remain nimble in portfolios. At the end of May we did opportunistically increase equity holdings slightly as, from a long-term perspective, we thought the sell-off looks advanced and pessimism had become consensual. Going forward we will evaluate if we can add some exposure to credit assets. In a growth slowdown – as opposed to a recession – credit may do well as an asset class despite the uncertain economic backdrop.
ESG MANDATE
OUR ESG MANDATE PROMOTES ENERGY TRANSITION
The world’s largest oil companies are seeing a continued increase in environmental, social and governance (ESG) concerns from shareholders and investors. Looking back on the voting behaviour on shareholder resolutions this year, ESG issues now account for 567 resolutions, with support for environmental proposals up by 6 per cent.
As a B Corp, Coutts has been at the heart of this. The biggest wins have been with oil giants such as Chevron and ExxonMobil. We continue to hold hydrocarbon companies as we are able to scrutinise and challenge any hold ups in their transition to net zero while providing value for our investors.
The number of shareholder proposals supported by Coutts on a variety of ESG issues has risen to more than 500 in 2022.
Number and breakdown OF Coutts supported shareholder ESG resolutions (2013-2022)
Data accessed March 10, 2022. Shows proposals filed as of Feb. 24, 2022.
Source: Sustainable Investments Institutes (Si2)
looking ahead
LESSONS FROM HISTORY
We understand that markets may appear risky at the moment and that every investor has their own goals. However, the best way to mitigate volatility may be to remain invested. This is because, historically, markets are most likely to recover and see growth beyond their last high point within 12 months. The below chart shows this through the worst recent crises:
Returns of different asset classes since 1988
Source: Refinitiv. MSCI UK £ used for Equity, Bloomberg gilt index used for Bonds, Gold Bullion price used for Gold, UK Sterling 3M deposit used for Cash. Returns include total returns and assume dividends reinvested, Data to 31 December 2021. Past performance should not be taken as a guide to future performance. e value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment.
Unless you need cash urgently, taking money out during a dip makes it extremely difficult to see invested gains if you then have to buy back in once asset prices rise again. We emphasise that short-term losses are ‘the norm’ when it comes to investing, however, over the long term, markets usually recover.
Since 1926, the S&P 500 has an annualised return of 9.7%. Breaking this down further, in 68 out of the last 92 years (71%), investments in the S&P 500 have had a positive annual performance. Over half of those years have seen 10%+.
FREQUENCY OF ANNUAL RETURNS
Long term annualised return S&P 500: 9.7% (since 1926)
Source: Coutts, Datastream
Coutts portfolios are diversified and designed to help mitigate undue risk. As we have illustrated in this report, we continue to monitor and tailor portfolios to protect clients’ wealth and take advantage of forthcoming opportunities.
The value of investments, and the income from them, can fall as well as rise and you may not get back what you put in. Past performance should not be taken as a guide to future performance. You should continue to hold cash for your short-term goals.
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