Market backdrop

Stephen Payne: The third quarter of 2022 was undoubtedly one of the toughest we have seen for markets in a long time. With high levels of inflation proving persistent, central banks have stuck to their guns and continued to push up interest rates even in the face of increasing recessionary risks. This has been a headwind for both bond and equity markets.

The fund lost just over 7% through the quarter, marginally outperforming its benchmark but not the IA peer group, as UK markets in particular suffered a torrid time. Gilt yields almost doubled through the quarter to over 4% for the 10 year, the pound depreciated 9% against the US dollar, and the FTSE All-Share lagged the S&P 500 by over 7% in sterling terms*. A lot of the damage was done in September, when UK markets were rattled by Liz Truss’s “growth” policy agenda and Kwasi Kwarteng’s mini-budget. This was compounded by the need for the Bank of England’s intervention in the gilt market, a response to LDI (liability-driven investments) issues within some pension funds.

Fund activity

Stephen Payne: In terms of positioning, we became more cautious at the beginning of the quarter, moving underweight equities, with this money moving into cash as we also remained underweight fixed income as well.

The equity portfolio underperformed its index in a tough quarter for active managers. The FTSE 20, the largest 20 UK companies by market cap, have held up well this year but the next 80 in the FTSE 100 and the mid- and small caps, have endured a much tougher time. As such, the FTSE 100 is down less than 4% year-to-date [to 30 September], whilst the FTSE 250 Mid-Cap Index is down more than 25%.

We believe the UK equity market continues to look very cheap, trading on a forward price/earnings ratio of only 9x against a 30-year average of 13.5x and global markets that are on 13x**. Within the market, cyclical stocks have fallen particularly hard. I’ve worked through quite a few downturns before over the years, but I don’t ever recall witnessing stocks discount a recession so quickly. Earnings downgrades are just beginning and [likely] there are more to come as sell-side analysts play catch-up with the buy-side, which has already moved to discount downgrades into share prices.

We are beginning to see an asymmetric risk-reward profile in cyclical names and we have begun to gently edge our way into some favoured [in our view] higher quality cyclicals in order to capture this upside. Examples include Intermediate Capital, the private markets fund manager, Genuit, the plastic pipes manufacturer, which is a play on infrastructure investment, and Future, the digital publishing group.

James Briggs: The bond portfolio outperformed the index due to conservative positioning, both in terms of interest rate positioning but more importantly in terms of credit quality, favouring both government bonds and defensive non-cyclicals over higher risk issuers.

Market strength at the start of the quarter, on optimism that we may have seen the worst from monetary policy tightening, turned sharply in August and September on continued evidence that inflation has yet to peak for this cycle. Expectations of further aggressive rate rises across developed markets led to negative returns across all flavours of fixed income.

Within the UK market volatility spiked at the end of the quarter following the fiscal policy shift from the new government. This led to concerns that the cost of the tax giveaway had not been sufficiently calculated and that the market would be unable to absorb the gilt supply that would be required to fund it. Despite a partial reversal on the top rate of tax, the volatility that followed has significantly impacted the amount of leverage that can be supported within pension funds’ hedging strategies, leading to the Bank of England providing emergency support to maintain liquidity within the gilt market. Volatility looks set to be a feature of the bond markets for the remainder of this cycle, supporting our decision to focus on higher quality credits, albeit the yields available are [now] significantly more attractive than we have seen for a very long time.

Looking ahead

Stephen Payne: Given the simultaneous falls in both bond and equity markets this year there has been increasing talk about the death of 60/40 funds, as the two asset classes have proved positively correlated on the downside. In our view this is a case of looking through the wrong end of the telescope.

We have been concerned for quite a long time now that bond yields were unsustainably low. This was obviously a risk for bond returns but also a problem for equity valuations as discount rates were too low. The upward adjustment in bond yields we have been fearing has come to pass, to be honest, much more rapidly than we could ever have expected.

However, it means that now, the returns on offer from bonds going forward are [looking] much more attractive. The yields available, now exceed those from the equity market dividend yield. We have often talked about having a structural overweight bias to equities over bonds given the respective risk/reward on offer. That is now a much more nuanced debate with the return prospects of both asset classes likely looking better from this valuation starting point. That is a positive outlook for a balanced fund such as ours.

Thank you for listening and we look forward to better times ahead.

 

*Source: Bloomberg, Janus Henderson Investors, 30 June 2022 to 30 September 2022, Janus Henderson Cautious Managed Fund. The fund uses a composite benchmark comprising 50% FTSE All-Share & 50% ICE Bank of America ML 5-15 Year Sterling Non-Gilt Index. The fund uses the IA Mixed Investments 20-60% peer group. Past performance does not predict future returns.

** Bloomberg, 30 September 2022. UK = FTSE All-Share Index, global = FTSE All World Index.

 

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