20 Dec 2022
Fundamentals return to spotlight
Article written by PSK's Chief Investment Officer, Chris Lioutas
Tis the season to ask Santa that the events of 2022 are learnt from but never repeated – macro and geopolitical driven markets, one of the worst years for bonds on record, and a year where diversification was the only free lunch you didn’t want.
We know that markets can and will be macro or thematic driven, but when they are, it usually only persists for a brief period. Almost three years is getting a little long in the tooth, but we are starting to see the light at the end of the tunnel. Markets are starting to refocus on fundamentals, which is what really matters over the medium to long term. Think earnings, balance sheet strength, margins, pricing power, cost management, cashflows, etc.
It would be remiss of us not to discuss the year that was without three main focal points – inflation, central banks, and China.
Inflation
Inflation sky-rocketed throughout the year. Fuelled by central bank policy that was too loose, lavish government covid stimulus payments, a surge in demand with covid reopenings, damaged or broken supply chains, and the Russia / Ukraine war which, disrupted the agricultural market (food) whilst Western sanctions disrupted energy supply bringing to a head food security and decades of underinvestment in base load power.
If that wasn’t enough, changing inflation dynamics caused by covid reopenings gained traction (ie. shift from goods consumption to services consumption) and exacerbated labour shortages as full employment took hold forcing up wages.
Some of this inflation is “transitory” (possibly the most overused and hated word of 2021). Some of it will take a little longer to resolve, with central banks doing their best to bring it under control to maintain their inflation-fighting credibility.
At the time of writing, inflation remains very high in almost every country except for China (lockdown effects) and Japan, though the latter now has the highest inflation they’ve seen since the late ’80s. We are now also starting to see signs of inflation pressures abating, specifically in the USA.
Central Banks
This leads us to central bank action and the extraordinary amount of policy tightening we have seen in a little over six months. The main aim is to crush demand to bring inflation under control whilst trying to avoid bringing about a damaging recession - usually referred to as a “soft landing”, or in this case, threading a very fine needle. It is worth noting that the rate hikes have been rapid (consecutive meetings) and in outsized increments. The lagged effect of these rate rises has yet to be felt. Historically, there is roughly a 3–9-month lag in economic impact following any one rate rise.
In 2022, the RBA moved from 0.1% to 3.1%, the US Fed from 0.25% to 4.5%, the European central bank from 0% to 2.0%, and the Bank of England from 0.1% to 3.0%. The policy tightening saw central banks reducing the size of their balance sheets - the reverse of quantitative easing or money printing - technically referred to as quantitative tightening. This has the effect of reducing liquidity in markets as well as increasing the cost to governments of financing their deficits. Central bank policy has resulted in some of the tightest financial conditions we’ve seen for some time which will no doubt play out in the economy in 2023 and 2024.
China
The last major factor of note this year is China. Their severe lockdown approach to covid shuddered the world’s second biggest economy, Australia’s largest export partner, one of the world’s largest manufacturing hubs, and a critical part of the world’s movement in intermediate and final goods.
This approach added to inflationary pressures but also hurt tourism and hospitality sectors globally as well as the education sector locally. Several reopening false starts added to market volatility and made supply chains almost impossible to manage, with many companies suffering from a shortage in inventories (understocking) and now likely to suffer from an oversupply of inventories (overstocking), which might make for some great Christmas specials!
The stringent lockdowns have also led to the most significant social unrest we’ve seen in China since Tiananmen Square.
The geopolitical tensions between China and other nations increased throughout the year, not helping risk sentiment. These strains seem to have subsided more recently, as covid reopening takes centre stage. Markets also eagerly awaited news of stimulus throughout the year, but little was provided absent some late assistance to the collapsing property sector and some signals to the banks to lend more freely.
What does this all mean?
One point we strived to reiterate throughout this year is that we are going into a period of significantly tighter financial conditions and an expected economic contraction from a position of strength – ie. we have full employment, rising wages, strong household and corporate balance sheets, and in the Australian context, a consumer with a still reasonable savings buffer.
That means a level of resilience that will hold economies in reasonable stead in 2023. At this juncture, it looks likely that Europe heads into recession (potentially deep), the US skirts with recession, and the lucky country that is our own avoids recession but with low levels of economic growth.
Interest rates will likely need to stay at these or slightly higher levels for a period of time to bring about a recalibration of conditions which inevitably will involve some things breaking.
Whilst market movements can be totally divorced from economic outcomes over the short-term, all the above factors largely had a negative impact on asset prices in 2022. What was more surprising, and interesting, was the level of divergence in returns between and across asset classes, regions, countries, sectors, and investment styles.
Value as an investment style finally had its time in the sun after an almost baron decade. The same can be said for good old cash. Australian equities outperformed global equities whilst developed markets beat out developing and emerging markets. Larger companies won handsomely over smaller companies. Listed infrastructure trounced listed property, with both losing out to broader equities. Unhedged currency exposure made a significant difference in returns as the Australian dollar fell sharply. And last, but not least…. well maybe so for 2022 anyway, a punishing year for bonds with Australian bonds outperforming global bonds. These movements will make for a very interesting 2023.
Outlook for the new year
What will 2023 bring? Let’s hope it’s a greater focus on fundamentals and a less macro and politically driven environment. But hope isn’t an investment strategy. We think central banks have already done a lot of the heavy lifting and a period of stability in monetary policy is likely. Whilst this might bring some calm and certainty in markets, it does mean the economic environment will continue to weaken through the course of 2023 as policy tightening brings about a reduction in demand. That means 2023 is likely to be a fruitful year for bonds but likely a mixed year for growth assets like equities, property, and infrastructure. We think there will be clear winners and losers, and we think the divergence in region, country, and sector valuations and mispricing within bonds should provide active investors with a very conducive environment. As always, stay calm, stay diversified, and remain focused on the longer term.
If you have any questions or your personal circumstances have changed please do not hesitate to contact your financial adviser.
General Advice Warning - Any advice included in this article has been prepared without taking into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs.
