Annus Horribilis

After many years of frustration and expensive losses, financial market bears have enjoyed their year in the sun. For the first time in almost a decade, stock and bond rallies in 2022 offered investors a chance to turn their backs on markets, as every low was followed by a rally that rapidly fizzled out before resuming the downward trajectory  towards the next low. Whilst there were places to hide in areas such as energy, share prices of businesses were punished irrespective of their underlying quality and qualities. Those investors seeking solace in government bonds, on the basis that the risk was negligible, suffered equally important losses as prices ground lower on the back of aggressive interest rate hikes by the majority of central banks around the world.

This meant that the age-old notion of a balanced portfolio, whereby bonds would cushion any losses in equities, turned out to be useless in a year such as 2022.

The hot debate during the year under review centred around the generally accepted conclusion that, over the past ten years or so, leading central banks had lowered the price of money, that is short-term interest rates, to a level perceived as artificial; and that this was achieved through the “asinine” policy called “quantitative easing”, a policy now mercifully defunct. What happened in 2022 was “chickens coming home to roost” according to these observers who had spent years in disbelief as share prices rose strongly. Few and far between were those who concluded that it was bond markets that guided central bank policies rather than the other way round.

Another source of debate surrounds the origin of the sharp renaissance in inflation experienced around the world. Certain observers would have it that inflationary pressures were in evidence long before Putin invaded Ukraine, while those observers who have long followed Putin’s imperialistic plans to weaponize energy, when the time was right, claimed that he seized his moment to overrun Ukraine when inflationary pressures had begun to be felt. In that respect, Putin managed to fool an important array of observers and, more importantly, European politicians regularly beholden to Russia, with the Germany of Angela Merkel in the forefront and now paying the price.

As long-term bond prices began their precipitous decline, the first victims of this trend were so-called long-duration assets, of which quality growth businesses became one of the prime candidates. The share prices of such businesses were placed in the same compartment as tech-heavy so-called growth stocks whose share prices had risen strongly on the prospects of future earnings and in spite of the absence, in many cases, of profits and that are saddled with high levels of debt. Even within the tech space, no difference was made between growth stocks and quality growth businesses whose ingredients and characteristics have long been discussed in these newsletters. The embedded notion of perpetuity of such businesses and the question of where the long-term value comes from were ignored by investors seeking to benefit from the  downward momentum of all such share prices.

As this annus horribilis draws to an end, inflationary pressures have subsided as well as their expectations for the future. Energy prices have fallen back, input costs have turned negative in many important economies, wage-price spirals have not yet materialised to the extent predicted by doomsters, and supply constraints have eased substantially from the days when ports and harbours were crowded by hundreds of vessels around the world.

That is the presumed reason why bond yields, having peaked at higher levels two months ago, have fallen back to levels which, according to pessimists, still represent a negative real return. Optimists, on the other hand, will argue that the direction and speed of travel both of inflation and of long-term bond yields is arguably more important than their absolute level, whatever their current return in real terms.

Many investors had turned their back on stock markets a while ago and sought refuge in the realms of private equity or private debt markets. The absence of daily quotations for such investments removes the anxiety felt by mainstream investors when marking their investments to market. (However, the absence of liquidity and daily two-way prices may turn out to be a false sense of security and a safe haven of illusion). With sentiment at an important low as 2022 draws to an end, investors are exiting the markets irrespective of share price weakness and the absence of liquidity. At the same time, the important role played by largely unregulated so-called shadow banks could represent the next shoe to drop in the case of a run by institutional investors who have been attracted to the private equity and private debt space.

Market liquidity is a complex topic. However, when world bond yields were at their highest some months ago and when the safe-haven-related external value of the US dollar was at its most extreme, the risk of a liquidity crunch was acute. This would have been felt by emerging markets with high levels of dollar-denominated debt and who are not producers of raw materials such as crude oil and natural gas to bail them out. But as so often happens in financial markets, that which needs to happen will happen. It was thus not surprising when the US dollar reversed its rise and embarked upon a decline still felt now that the year is coming to an end.

The residual question that now remains is who is right? There has been a sharp increase in central bank rhetoric about doing what it takes to tame inflation at the same time as bond yields have stopped rising and have reversed their course. Even the surprise effect offered recently by the Bank of Japan seems to be receding. Still, the Japanese style and defensiveness when justifying its move, shows how the combination of temporary market dysfunction and a liquidity squeeze makes central bank messaging more important today than in normal times.

There appears to be a difference of opinion between bond markets and central banks, but one in which the traditional bond vigilantes of the earlier months of this year have gone to ground. But both camps cannot be right, and as long as differences of opinion remain wide, so too will the market’s expectations (and hopes) for the future.

If that which needs to happen in financial markets eventually does happen, the characteristics of quality growth businesses will sooner or later prevail and be reflected in their share prices. Of primary importance is the concept of perpetuity and the realisation that long-term cashflows expected from years five to ten, and beyond, will be the main drivers of share price performance. Our investment team will cover these topics in more detail in a newsletter later this year.

Meanwhile, I would like to wish our readers a successful new year 2023.

P. Seilern,

30th December, 2022

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