Market backdrop and portfolio impact

Coming into the start of 2022, the biggest issue facing markets was surging inflation and what the central bank response would be. Inflation has consistently surprised to the upside, a legacy of the COVID pandemic. Higher inflation has been driven by both supply bottlenecks and excessive money supply growth, with government hand-outs during the pandemic and very low interest rates fuelling demand.

For us, the primary risk facing the portfolio was sharply rising interest rates, feeding through initially into rising bond yields. That left us in the unusual situation where the fixed income side could potentially pose a higher risk than equities. So we started the year positioned overweight equities relative to bonds. Rising yields do also pose a threat to equity valuations, especially amongst more highly valued growth stocks, so we had more of a value style tilt to our equity portfolio relative to a UK equity market that already has an inbuilt value bias.

As the first half of the year played out, inflation stayed higher and stickier, exacerbated by the impact on commodity prices from the tragic events in Ukraine. So central banks became increasingly more hawkish, with the scale and frequency of interest rate hikes accelerating. This drove bond yields higher causing bond returns to be negative. As we reached the half year point, the primary concern of markets started to shift more to the risk of a recession, driven by the sharp tightening in monetary policy.

We share these concerns and so we have been taking a more defensive stance in the portfolio, both through asset allocation, reducing our equity weighting, and increasing cash, while also shifting the underlying risk profiles of both the equity and bond portfolios. Our equity weighting has come down from 55% coming into the year to just below 50% at the end of June.

One of the more challenging features of the first half is the positive correlations between risk-free and risky assets, with most financial assets falling together. The hangover from stimulative monetary policy fuelling excessive valuations has now at least partially played out. With the market outlook becoming more multi-dimensional, we believe the usual negative correlations may reassert themselves going forward. We have already started to see that in recent weeks in the credit markets, and believe that the hedge characteristics of bonds, relative to equities, may continue to normalise in the months ahead.

Positioning, performance and outlook

The fund outperformed both its composite benchmark and the peer group in the first half. The aforementioned asset-allocation positioning was beneficial as we saw the unusual scenario of both equities and bonds actually declining, bonds declining more so than equities.

The other driver of outperformance came from equity stock selection. The portfolio was deliberately biased to “value” style equities and has thus benefited from the rotation in markets from growth to value as bond yields rose.

A good sector to demonstrate this for us is Consumer Staples. We do not hold Diageo. It is a high-quality business in our opinion, although the high rates of growth it has delivered of late are unlikely to be sustainable. Our issue was much more about the valuation ascribed to the shares. In our view, they are simply too expensive, having re-rated as a growth bond proxy in recent years.

Conversely, tobacco companies are a big overweight for us. They are the value end of the consumer staples sector, unpopular in recent years but now offering modest but stable growth and very high free cash flow yields which help to fund big dividends and potentially buybacks too.

Another unpopular sector where we took a contrarian view coming into this year was Oil. It is a relatively big sector in the UK market and yet we were overweight. Long term underinvestment in the industry has resulted in a situation where the oil market is very tight, pushing up oil prices. This has obviously been further exacerbated by Russian supply constraints following Putin’s invasion of Ukraine.

Another success in the first half has been ongoing bid activity in the UK equity market. Our investment process has identified high quality businesses with good returns, decent growth profiles and strong cash generation which have also appealed to private equity and corporate bidders too. During 2022 year-to-date, we have received bids for Homeserve, a home emergency repairs business, Brewin Dolphin, a wealth manager, and Euromoney, the B2B information provider.

Looking ahead, after what was undeniably a tough six months, we see the outlook as brighter going forward. We are treading cautiously in the very near term, but we are starting to see opportunities for long-term investors like us, to take advantage of attractive valuations and yields on both sides of the portfolio.