When looking at performance numbers, January looks on the surface to have been a quiet month. Our fund was flat in January while the overall UK stock market was very slightly up. We were hedged for much of the month but did take the hedge off1 as the month drew to a close.
At the start of the year, we felt concerned that the stock market was overbought, and that positive sentiment was too high. At the same time, the whole direction of monetary policy was shifting and potentially shifting dramatically. Towards the end of January, we had a much better picture of what central banks are up to, and at the same time, some of the most extended areas of the market had pulled back noticeably. This was especially the case regarding technology investment where NASDAQ has had one of the worst starts to a year in its history. The UK market has performed steadily during this tech pull back and is a sector with few tech companies. To a certain extent, the UK market could almost be regarded as the inverse of NASDAQ. This stability has been encouraging to us, and it was this, along with a strong swing in investor sentiment from quite positive to negative that convinced us to remove the hedge.
The other reason we felt that it was reasonable to remove the hedge was that the world now has more visibility regarding central bank intentions. The UK has already put-up short-term interest rates and may do so again this month. In the US the central bank finally sounds as if it is more determined to act to put up interest rates. Although it is entirely outside the current consensus we are now starting to consider if concerns about the outlook for inflation may be a little too elevated. It is certainly the case that there have been very high inflation numbers seen in both the UK and the US. However, the correlation, in the US between the change in M2 (a measure of money supply) and inflation hints that inflation may moderate as the year goes on.
Although the relationship between changes in the money supply and inflation are often not perfect, it does seem that the recent inflationary surge that we have seen in the West was substantially driven by the huge expansion in M2 seen over the last few years. In essence the super-fast growth in the money supply that we have experienced is now going to slow dramatically. It does take some time for changes in the money supply to feed through into the real economy, but all things being equal, a notable moderation in the inflation rate is possible in the second half of 2022.
If this occurs, then all the more excitable commentary about how the West is going to enter a 1970s style inflationary spiral would disappear. This is especially the case because we also now know that central banks are going to steadily increase interest rates, at least through the first half of this year. It is often the case that equity markets can become turbulent ahead of a turn in monetary policy, but that once the market can quantify with more clarity what is going to happen then it can regain its feet.
It is often the case that when stock market investors are very concerned about something then usually, by the time the concern is universal, the issue is somewhat discounted. If current concern about inflation has reached this point, the concern about inflation may shift into worries about a lack of economic strength. It is notable how weak surveys of US consumer sentiment have been recently. It is also the case that savings ratios, which had risen dramatically during lockdown, have now pretty much returned to their normal low levels, suggesting that any pent-up spending may have already occurred. On top of this, post the pandemic spending, UK government debt to GDP is now at over 100%. Academic literature suggests that a debt to GDP debt level of over 100% tends to lead to muted economic performance.
We are also curious about how small the increase in long term government bond yields has been. The highest yielding point of the UK government bond yield curve is a rate of 1.52% (20-year duration). While longer term bond yields are above their lows the selloff is mild compared to where current inflation rates are. Either the bond market does not believe inflation is going to be a problem or quantitative easing has helped, so far, to keep a lid on rates. A bit of both seems plausible. However, from where we are now if the Bank of England is to steadily increase base rates this year, then, unless longer dated bond yields start to rise, the overall yield curve will start to notably flatten. If long yields stay where they are it would only take an increase of a little bit more than 1% in base rates for the government bond yield curve to become inverted. If this does occur, which would take some time, it is worth pointing out that an inverted yield curve has historically been a most reliable forecaster of recession. Covid, and the monetary response to covid, may have interrupted and possibly extended the current cycle, but in the end all cycles do come to an end. The early 1990s recovery lasted until around 2000. From there the next recovery lasted until the 2008 financial crisis. If the current cycle emerged from the 2008/9 financial crisis, then we are now in the right area to be considering the end of this cycle.
We will continue to watch bond markets closely. Historically the first few increases in short term interest rates are not too disruptive to equity markets, as stocks start to be driven more by earnings growth than interest rates. If however, the yield curve starts to notably flatten then earnings forecasts start to become a lot less certain. The risk ahead may well be that earnings forecasts are too high, and as the year rolls on it may become more apparent that we are near the end of this cycle rather than at the start of a new one. This year could turn out to be surprising and as always, we will negotiate markets carefully.
TOP FIFTEEN EQUITY HOLDINGS 31st JANUARY 2022
AstraZeneca 6.0%
Shell 5.2%
HSBC 5.1%
BP 4.9%
Diageo 4.1%
Rio Tinto 3.8%
BATS 3.2%
BHP Group 3.0%
National Grid 2.9%
Relx 2.4%
Compass Group 2.4%
Unilever 2.2%
GSK 2.2%
Prudential 2.0%
BAE 1.9%