— Jan 19, 2023


The FTSE100, a good measure of UK equities, was essentially flat over the course of 2022 which suggests a measure of calm. History books will be unlikely to concur with that assessment of the year. 

Last year we saw the Russian invasion of Ukraine – the largest armed conflict in Europe since World War 2 and the linked surge in oil and commodity prices as Russian energy supplies to Europe were severed. The global population reached 8 billion and we lost our Queen after her astonishing 70 year reign. 

In financial markets we have seen inflation surge into double figures – an outcome that “surprised” the 400 PhDs employed by the Federal Reserve, the Bank of England, the IMF and every other national and supra-national economic body. That inflation was the inevitable outcome of the largest splurge of government largesse (the lockdown payments) ever witnessed allied with supply chain issues (also lockdown) appears to have bypassed the global elite. 

In truth it is unlikely that central banks believed that inflation was not going to happen or, when it started to appear in the data, that it was “transitory”. They just wanted it not to happen and so their analysis led them to that published conclusion. The reason that they wanted to wish inflation away is because raising interest rates in the face of an oncoming recession would exacerbate the economic damage. 

At the end of last year we wrote the following: 

“On the evidence that we have today, it is no longer a question of if the Fed will be behind the curve when it comes to combating inflation. It is already clear that the Fed is too late and that this is deliberate. 

The Fed is so scared of causing collapses in asset prices, and plunging the US economy into a recession that it will keep interest rates too low too late. By some calculations interest rates should be at 6% by June this year in order to combat inflation. At present the Fed is not expecting to raise interest rates at all by then. Businesses are already preparing for this; rising stock levels and working capital. Wage inflation is already rising.

Just over a year ago the Fed predicted inflation at the end of 2021 of 1.8%. The actual level of inflation was 6.8%. This is neither a trivial nor modest miscalculation; they were miles off. Not only is inflation no longer transitory, it is no longer within the Fed or the BoE’s control. Their credibility when it comes to their ability to predict and control inflation has been fatally undermined and investors should place no confidence in their statements.”

Inflation will fall in 2023 as a technical consequence of commodity price rises from early last year dropping out of the calculations, but please regard the inevitable self-congratulatory pronouncements from politicians and central banks with deep cynicism. Underlying inflation (CPI excluding energy inflation) is around 6.3% and this is sticky because it has become wage inflation which is highly durable – wage demands are only moderate when inflation expectations are low. How many years will this take? It took Paul Volker four years as Chair of the Fed to bring inflation under control between 1978 and 1982, and required two deep recessions. 

Until interest rates are sufficient to force down inflation then it will persist. The question for investors though is less about when this will happen or how high interest rates will get, it is about how much of this has been factored into asset prices already. Certainly the presence and stickiness of inflation is no longer the surprise (to many) that it was at the start of last year and asset prices have been correcting. While the UK stock market has been stable this has been the exception – the US stock market (S&P 500) is down by 20% and the tech focused NASDAQ is down by nearly 35%. We have seen the collapse in tech valuations in the US; Tesla’s share price for example (which we have long viewed as unsustainable and irrational) has fallen by 70% over 2022. We have seen the (also irrational) prices of crypto “assets” crumble in the face of loss of confidence and outright fraud. Chinese property values – another product of excess – have tumbled. Other asset classes have reacted: debt markets have seen falling valuations, as have property and most commodities and alternative investments. Private equity has fared better, but this is a fudge; they choose the valuations of their assets and most have not adjusted their valuations downwards despite the stock market falls. This will flow through in 2023. 

Markets have started to incorporate bad economic news, but have they corrected enough? PE ratios suggest that they have not. The PE ratio or price earnings ratio is a useful measure of valuations. Today the PE ratio of the US stock market is 28x: the average price of a company is 28 times its historic earnings. This is considerably lower than at the start of the year but remains substantially above its long term average of 17x. This is one concern, however our bigger concern is less with the multiple of profits (the P) than about the profits themselves (the E). Have profits forecasts fully reflected the coming earnings recession? Our analysis of stock market profits forecasts is that they have not and so further stock market falls are likely. 

In some areas the earnings falls have been better understood and we would certainly view US technology companies in this light – the sentiment around US tech is quite bleak. And some companies, such as consumer durables and utilities, may be able to continue growing profits as their businesses are resistant to inflation setbacks. So there are investment pockets that will do relatively well but in the absence of interest rates falling (highly unlikely given current inflation but not impossible given central banks reluctance to acknowledge or fully address it) or further bouts of economic stimulus (again, unlikely but not impossible) it is likely that stock markets will fail to push ahead in 2023.      

In the UK we do not expect a repeat in 2023 of the second half of 2022 which saw an improbable five Chancellors of the Exchequer, three Prime Ministers and two Monarchs, but we do expect a continuation from the main threats we identified at the end of 2021:

  • sustained high inflation
  • higher asset price volatility
  • wage increases 
  • increased union activity / strikes
  • higher inventories and working capital
  • shorter, more local, supply chains
  • lower return on capital employed (ROCE), profits and margins
  • higher energy costs

We left 2022 much as we entered it – with a highly defensive position: high levels of cash, low credit risk and duration, significant gold reserves and a focus on cheaper equity markets. This has protected our clients wealth as well as possible given the impact of falling prices over all asset classes in 2022. We do not foresee changing our defensive positioning until markets better reflect the underlying economic fragility of earnings. 

This, however, is not a counsel of despair. There is an investing adage that should be noted; you make most of your money in a bear market; you just don’t realise it at the time. 

That is you can buy assets at good prices but you only see the profits from that wise investment in future years. 

Also the seeds of the next growth phase develop during recessions; they are medicinal and cathartic. Recessions cleanse economic systems of bad decisions, over-investment, failing business models, and poor productivity, and this cleansing leads to better economic outcomes for companies and society. Much as forecasters are too slow to see recessions coming they are too slow to see recessions ending. In this regard stock markets are lead indicators – they tend to rise before the economic data shows recovery is coming and then rise strongly when the evidence emerges. 

It appears that 2023 will be premature for the economy to fully absorb the impact of high inflation and rising interest rates and so we are maintaining our defensive position and our focus on assets that protect against the damage inflation brings, but we will sustain our focus on locating attractive assets at reasonable valuations – the key to every successful long term investment strategy.    

sources: SORBUS, multpl.com/shiller-pe, ONS