Neil Birrell
Premier Miton’s Chief Investment Officer
Year out
At this time of year, it’s normal to look back on the year about to end. In the ‘In Favour / Out of Favour’ note I wrote last month, I outlined the changes we made to the asset allocation of the Diversified funds through 2022, which reflected the changing economic and financial market outlook, so let’s summarise that before looking ahead to 2023.
Bonds; significantly increased weighting, from low levels.
Equities; exposure at lows compared to history.
Property companies; favoured early in 2022, asset class has come under pressure.
Alternatives; remain key and core.
Portfolio hedges; remain in place (can be thought of as insurance policies).
Currency; foreign currency exposure now partially hedged.
Year in – economies
The word that is getting used more than most to describe the outlook for economies and markets in 2023 is “uncertain”, and I think that is as good as any. Obviously, we never know what is going to happen, but we can have a view on what we think might happen; so, let’s have a go at that.
At the top of the agenda must be the economic outlook. There are times when major regional economies are more synchronised than others and we may be entering a period when they are less in sync. This causes greater stress in the global economy, as demand and supply patterns shift and currency moves can have a significant impact.
The US is the world’s largest and most important economy, it is a key driver of what happens elsewhere and it appears, for now, to be in pretty good shape. Next up; China. COVID induced lockdowns and protests, a highly stressed property sector and tightening regulations may cause the economy to slow at a concerning pace, which is not good news. The Eurozone, for now, is surprising on the upside, but that is unlikely to last, whilst the UK is already in recessionary conditions, with little to look forward to in 2023. Meanwhile, Japan remains hamstrung by historical structural issues.
This means that government and central bank policy is likely to vary from one region to another as the twin threats of high inflation and slowing economic growth are addressed.
Year in – financial markets
I guess this is the bit we really care about; are we going to make any money in 2023, after what was, for most asset classes, an unprofitable 2022?
Back to that word again, I can’t say that will be that case with any certainty and I’m not about to say where markets are going in 2023. However, at a dinner recently I was asked by our Chief Financial Officer when I thought markets would bottom out. I am not going to give the date here, but it was in the first half of 2023. If you think I could be correct; that’s the good news. The bad news is it means prices will fall from here, but let’s have a more in depth look at that, or at least for the investment universe of the Diversified funds.
Bonds have fallen so far, so fast, that the fear of “catching a falling knife” has probably stopped many investors taking advantage of what, frankly, looks like a good entry point. But – yes, there’s always a but, and quite a few of them – interest rates are still going up and there is no evidence that inflation has peaked everywhere, let alone been beaten.
Furthermore, the bond market is not homogeneous and picking the right part of it, let alone the right bond, will be crucial. The high yield market does not feature much in our list of favourites as economic conditions worsen in the face of a much tougher re-financing backdrop; default rates are very likely to rise. There are attractive returns available in short dated investment grade credit to keep us happy and whilst yields might not fall much from here, the risk vs. reward available and the power of compounding returns make this an asset class we favour as we move towards 2023. Government bonds do have attractions in some regions, but not enough for us.
Equites have reached valuation levels that, on the face of it, look attractive, certainly in terms of the price / earnings ratio. However, we remain worried about the earnings part of that ratio. Economic activity is slowing, borrowing costs are rising and profit estimates are not, in our view, reflecting those factors. Therefore, as a result, equity markets are more expensive than they appear. This is one of the major reasons we think there is downside to equities, overall, from here.
As with bonds, equities are not a homogenous asset class, they vary by region, industry, size, quality and valuation, amongst many other factors. That’s why being active in terms of not replicating benchmark indices and in terms of reacting to market moves, should pay (literally) dividends in the conditions we are facing. So, we like equities, (those that we invest in), not as much as we have in the past and we would expect to get keener on them as we go through the first half of 2023, as the outlook gets clearer, the profits downgrades come through and prices are lower.
Property companies have suffered as recession has loomed. They have gone from being beneficiaries of inflation, to pariahs of recession. Property transactions have collapsed, as have their prices and the share prices of property companies have followed suit. They have hit valuation levels rarely seen before, but it is difficult to see them improving in the short term. We have maintained a reasonable weighting and will continue to do so. To continue the theme; we do not know what will happen, so staying invested in higher quality property companies in what we see as more attractive sub-sectors makes sense to us. We can’t time an exit and entry point exactly, so we will adjust weightings as opportunities rise and fall.
Alternatives remain a core focus. They diversify the funds’ investment portfolios into asset classes that we believe are lowly or negatively correlated to bonds and equities, that’s certainly how they have performed in the past. They typically become more correlated in periods of market stress as liquidity worsens or investors sell assets that haven’t fallen as much. Again, I can’t say that won’t happen, but prices do recover.
Portfolio hedges, we think of as our insurance policies. They have been a feature of the funds for a number of years now, to a lesser, or as they have been through 2022, a greater degree. As I am writing this, we have modestly taken out a bit more insurance on our equity exposure. If the playbook above works out, we will be making our claims in the first half of next year. Then, we will see. That is active management.
Across the range
The views expressed are reflected, proportionately, in the asset allocation of the four growth funds, the Income fund and the sustainable growth fund. The Income fund and sustainable growth fund have different underlying holdings in order to meet their specific needs.
Finally
Thank you for supporting the Diversified fund range in 2022. It was a tough year for managing the funds, but so were 2020 and 2021! We remain focused on building portfolios with the appropriate risk and reward profiles for each of the funds in their own right and relative to each other.
Whilst I have expressed my views, and those of the Diversified funds’ investment team, above, these are predicated on geo-political matters in Ukraine and China not escalating and we may well be wrong. Most importantly, we will play what we see and adjust the funds accordingly.
