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Keeping a cool head in volatile markets

21 January 2022

Inflation has been rising and in the UK we expect it to rise further, as fuel price increases feed through following the lift of the energy cap.

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Jonathan Marriott, Chief Investment Officer

Are we looking at bad news for bonds?

Inflation has been rising and in the UK we expect it to rise further, as fuel price increases feed through following the lift of the energy cap. Inflation has been driven by a pickup in demand as the world recovers from the pandemic, or at least learns to deal with it, combined with a lack of supply. Later this year and into 2023, we expect these pressures to ease and for inflation to come back towards the central banks’ 2% target.

The rise in prices (particularly heating costs), in addition to the potentially higher interest rates, may further constrain consumer demand. On the supply side, capacity is being increased in many areas, including computer chips. In the US, the market already prices in four 0.25% rate rises this year as well as a reduction in central bank assets. Overall, there may be a lot of bad news for bonds and thus growth is already in the market. 

When the FTSE 100 index is up, why are portfolios down so far this year?  

For several years, we have looked to diversify portfolios globally, keeping in mind that the UK market makes up less than 5% of the global index. Within the UK, the FTSE 100 is a poor index to use. It is heavily concentrated in materials, energy and financials, with a low exposure to technology, which has driven returns of global indexes through the pandemic and the years prior to it, leading to a so-called value bias in the index.

Indeed, the move this year can be attributed to just four stocks (HSBC, Lloyds, BP and Shell): large positions in the index in two sectors. The skew in the index has given rise to it outperforming the rest of the world in the first couple of weeks of the year, after many years of underperformance. It also performed better in the value rotation at the start of last year, despite ending up behind the global index. In 2020, in the grip of the pandemic, the index fell 11% - meanwhile, global equities ended the year up 13%. In fact, there was not a single calendar year in the last ten that the FTSE 100 outperformed the MSCI World index.

Within our core portfolios, we have a preference for quality growth companies and funds that select them. These have long-term growing earnings that may be valued using a long-term discount rate.  When bond yields rise, they tend to underperform for a while, which is the case this year.  In the long run, growing earnings compounded over time will outweigh the rise in discount rate on valuations and, at times of economic stress, these companies tend to outperform.

We also look for companies that retain pricing power when costs rise, as they are at this moment. Rising inflation and interest rates have put short-term pressure on these holdings, but in the long run we expect them to outperform again. In the first quarter of 2021, these stocks lagged but at an index level recovered later in the year.

Energy: a sensitive sector

The energy sector rise has been driven by increased oil prices. These have been highly volatile with higher prices often leading to higher production and a lag that leads to price falls. Oil is highly sensitive to slowdowns in the economy.

Let us not forget that the West Texas oil future was briefly negative in 2020 and, even if you take that dip out, it was as low as $20 per barrel. Today, it is over $80 per barrel. However, I would not wish to chase this after a strong period of performance. Environmental considerations are driving a move away from fossil fuels and many investors have shied away from the sector.

Some companies are making efforts to diversify but, with the green agenda, drilling for fuel may have a limited life. Despite the recent performance, in the long term the energy sector has been a poor performer with more volatility than return. Rather than guessing the next move in the oil price, we prefer to look at companies where earnings are more predictable. 

Our long-term approach

The graph below shows the global energy sector compared with the FTSE 100 and global growth and value indexes, including the Fundsmith equity fund. This is one of our core funds; its mantra has always been “buy good companies, don’t overpay, do nothing”.  It has fallen sharply in the first two weeks of the year, down over 8% underperforming the global index, which does happen from time to time. That said, the manager isn’t changing strategy and we continue to favour such funds.

MSCI world in sterling terms

MSCI graph

While careful to not ignore the UK equity market, we have seen many better opportunities in global equities and continue to do so. Whilst it has been a difficult start to the year for funds with a quality growth bias, we recognise that it is only three weeks into the year. In the long run, we believe this will be the right strategy to follow.

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