It is now two months since the Russian and Ukrainian conflict started. In March we were up a little over 2% and over the first quarter 4.3%. This compares to the overall UK equity index which was up around 1.7% in the first quarter. We are pleased that we have outperformed the market, avoided any notable drawdown, and made money during this tricky period. The fund goes ex-dividend (GB1.25p) at the end of March. By the end of March, we were fully hedged again as sentiment is no longer negative, the market is back to pre-war levels and the UK is facing the worst fall in living standards since the 1950s.
Often in financial markets, the issue that attracts the most news coverage is not necessarily the one that investors should be paying the most attention to. Although the Ukrainian war is a significant event, the market is now fully aware of what most of the issues are. When full attention is focused on one issue it is often prudent to understand what is happening away from the headlines. For us, this issue is the determination on behalf of Western central bankers to get inflation under control. Certainly, the rhetoric coming especially out of the US and the UK’s central bank has been getting more and more hawkish. Interest rate increases are scheduled for the whole of this year and into next.
There has also been a notable flattening of sovereign yield curves. Although yield curves are not negatively sloped, such a situation seems likely as short term rates rise. Once a yield curve is negatively sloped then it makes little sense for a bank to lend money for the long term as yields are higher in the short term. This does have a real economic effect and most of the time a negatively sloped yield curve is a very good predictor of a recession in the relatively near future. Quite a lot of commentary has already been made about this issue in the financial press and much of it is predicting immediate doom. Our own work on this issue leads us to conclude that while yield curve inversion is a reliable predictor of both market and economic distress it does take time to work. The two most significant examples were when Western yield curves inverted in February 2020 and again in October 2006. In the first example, stock markets peaked in August 2000, meaning that selling immediately when the yield curve inverted meant getting out six months too early. In 2006 it took a full year after yield curve inversion before the market declined. Consequently, from our perspective it is a little too early to get overly negative about yield curve inversion. However, if it does occur, we will take a particularly cautious approach in the months after it happens.
What has been less well covered is central bank balance sheet normalisation, also called quantitative tightening (QT). There is only really one good example of this, which was 2018. After substantial periods of quantitative easing (QE) central banks can deploy QT to do the opposite of QE. Instead of buying bonds from the market, central banks can effectively sell excessive amounts of bonds back onto the open market. This, along with the need for governments to fund themselves means that the amount of free liquidity that could flow into equities is diverted into fixed income. It is also logical to assume that this will cause upwards pressure on interest rates.
From public speeches made by a variety of central bank officials it now seems likely that QT could be introduced by the late spring or early summer of this year. The last time this was tried in 2018, a high-profile central banker famously said that “QT would be boring, it would be like watching paint dry”. This did not turn out to be the case. Unlike the delayed effects of interest rates, and or yield curve inversion, it turned out that QT had a negative effect on equities almost immediately. Eventually, by the end of 2018 the US central bank had to abandon the programme following a decline in major stock markets of almost 20% and increasing evidence of a looming liquidity crisis.
Unlike interest rates and yield curves that effect the real economy, a policy of QT is less of a real-world event and more of a financial market phenomenon. The economy could still be doing fine but dramatically less liquidity could mean a derating in equity valuations. This is especially notable because current US equity valuations are high, certainly higher than in 2018, and the amount of QT that is needed is potentially much larger than in 2018. It is this risk, rather than actual interest rate or yield curves that concerns us the most.
As a final note on this point, right at the start of what may be a long period of tightening central bank policy, some investors appear excited by tightening because they believe that the consequent slowdown will lead to another round of QE. It is possible that the current tightening plans will end early if economies do weaken notably, but, given the current inflationary environment, it will take a meaningful economic slowdown, or notable financial market distress before such a change in policy is likely. This view, where tightening is being equated to easing, and ultimately more QE, also indicates a deeply ingrained bullish stance. This mix of Panglossian enthusiasm along with some of the most challenging economic and political conditions in decades is not, in our view, an attractive environment.
As always, we would like to thank everyone involved with our fund and we will proceed with caution.
TOP FIFTEEN EQUITY HOLDINGS 31st MARCH 2022
Rio Tinto 4.3%
BHP Group 3.6%
National Grid 3.0%
Compass Group 2.3%