2023 Outlook: Neil Hermon, Portfolio Manager

Neil Hermon

Portfolio Manager

28 Dec 2022
2 minute read

2022 has been an extremely difficult year for equity markets especially UK mid and small caps. The reasons for this are well known and include slower economic growth in China, the conflict in Ukraine, rapid escalating inflation and the pressure this is putting on consumer spending, the hawkish shift by Central Banks towards higher interest rates and the move from quantitative easing to tightening and more recently political turmoil in the UK.

Looking into 23, although macro-economic conditions remain difficult and likely to become more challenging, there are reasons to be positive. Although corporate earnings are likely to be under pressure, valuations have compressed significantly.

The UK market looks cheap under almost any measure compared to history and other international markets.

Corporate earnings performance remains robust and importantly balance sheets are strong with generally low leverage prevalent. Indeed over half our portfolio by value have balance sheets with net cash. Corporate confidence in their own future is evidenced by rising dividends and a number of companies buying back their own equity. Additionally we continue to see inward M&A transactions from overseas and private equity players.

There are a number of potential catalysts which could help the equity market recover. The first would be a relaxation of the Chinese zero tolerance policy to COVID. Secondly any resolution to the conflict in Ukraine would be very positive for sentiment and also significantly help decrease inflation as oil and gas prices would likely reduce. However there seems to be little progress in this regard. More importantly the market needs clarity on the likely peak in inflation and interest rates, an area where there has been a fairly constant level of disappointment throughout 2022. However there are signs that we are approaching the peak in both these measures. This will allow the equity market to look ahead with more certainty and allow more a considered perspective on equity valuations.

Definitions

Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.

Quantitative easing (QE): An unconventional monetary policy used by central banks to stimulate the economy by boosting the amount of overall money in the banking system.

Quantitative Tightening (QT): A government monetary policy occasionally used to decrease the money supply by either selling government securities or letting them mature and removing them from its cash balances

Balance sheet: A financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders. It is called a balance sheet because of the accounting equation: assets = liabilities + shareholders’ equity.

Leverage: Leverage has multiple meanings:

1. An interchangeable term for gearing: the ratio of a company’s loan capital (debt) to the value of its ordinary shares (equity); it can also be expressed in other ways such as net debt as a multiple of earnings, typically net debt/EBITDA (earnings before interest, tax, depreciation and amortisation). Higher leverage equates to higher debt levels.

2. The use of borrowing to increase exposure to an asset/market. This can be done by borrowing cash and using it to buy an asset, or by using financial instruments such as derivatives to simulate the effect of borrowing for further investment in assets.