Almost a century ago, in a seminar discussing the nascent science of quantum mechanics Niels Bohr, the Nobel laureate and father of the atomic model, remarked that "it is exceedingly difficult to make predictions, particularly about the future". This is what passes as cutting-edge humour among quantum physicists; if you can't model the here and now, extrapolating the future is fun but futile.
For we humble investment managers, it reminds us that models of 'rational' market behaviour are based on past data that may not recur. This has certainly been the experience in 2022; assets' relationships that have held good for decades for the most part collapsed during the year.
December has reinforced that experience; a festive phenomenon that annually exercises juvenile financial reporting is the fabled 'Santa rally', where stock markets are expected to rise in the period leading up to Christmas. At the time of writing* however, Saint Nick had clearly placed most markets on his naughty list, with only Gold and the Chinese stock market producing positive returns for sterling investors during the month.
Bonds' recovery stalled too, with fixed-income benchmarks falling by up to 6% during December. Markets' collective views that a pivot towards easier money was on the cards were squashed by central bankers' somewhat belligerent comments following more interest rate rises in the US, UK and the EU. These messages were confirmed when 'out of the blue' the Bank of Japan reversed its stated policy of maintaining the 0.25% 'fix' on the 10-year bond yield, allowing the rate to double. This quasi-rate rise leaves China as the only central bank not to raise rates. Collectively, the world's interest rate rises have surpassed 70 percentage points in 2022. This certainly implies slower global growth, and market players now seem to have got the message that the referee is still playing hardball despite a more positive outlook on inflation.
On to 2023
So, on to 2023, and no forecasts but rather an acknowledgement of the 'known unknowns'. Last month I pointed to corporate earnings as a long-term driver of share prices, but that the price people were prepared to pay for those earnings can fluctuate wildly. In May 2021, US investors were prepared to pay 44 times (ie years' worth of) the average current earnings per share of their largest 500 companies. That 'multiple' of earnings per share has dropped dramatically and is now a little over 20 – in line with the long-term average. In the UK, over the same period that multiple has dropped from 28 to less than 12, versus its long-term average of around 18. On that basis, the US looks fair value, and the UK looks cheap - but that doesn't mean it can't get cheaper; current earnings estimates may prove to be overconfident if business conditions deteriorate.
Demand is another obvious source of market momentum. House price growth is closely correlated with investors' sense of wealth and their propensity to invest. Ex-lockdown, house sales are the lowest in a decade, as are mortgage approvals. This is understandable as the cost of owning and maintaining a home – energy bills and mortgage rates – have rocketed this year. In 12 months, the cost of servicing a £200,000 mortgage has risen by over 150%, and that cost now represents 40% share of income, versus 25% in 2021. Prices are forecast to fall further as a result.
Depressing as this may sound, experience tells us that known unknowns can produce positive surprises (eg a shallower recession than expected, China's post-COVID recovery, a negotiated settlement in Ukraine) can produce sharp recoveries and a sea change in positivity. Then there are the unknown unknowns which are by definition unforecastable. However, our diversification process is well-positioned to navigate a wider range of either outcomes.
Markets can advance dramatically even amid adversity, again challenging the worth of forecasts. One large nation has suffered an autocratic leader whose meddling in financial policy over several years has made recent UK economic leadership appear downright sagacious. That nation's stock market saw its earnings multiple halve last year as a result. Its foreign exchange reserves are petering out and its inflation rate is over 80%. The result? A market collapse? Well, its domestic investors saw shares in domestic equities as the only hedge against inflation and piled in. Its stock market has risen 210% in 2022.
With absolutely no apology for festive irony, that country is Turkey.
Here's wishing everyone a safe and prosperous 2023 and see you next month.
Chief Investment Officer