December 2022

“Now this is not the end.  It is not even the beginning of the end.  But it is, perhaps the end of the beginning.” Winston Churchill

And thus, not with a whimper but with a bang did 2022 pass into history.  The year, which saw the most serious attempt to normalize monetary conditions since the Global Financial Crisis witnessed, an unprecedented scale of monetary tightening which upset both markets and economies.  To be sure this was not the first attempt – the tightening cycle which began in 2018 might have resumed but for the lockdown tsunami and the alchemistic seduction of “Modern Monetary Theory” but the surge in inflation was too significant for central banks to ignore forever.  Now, after a torrid twelve months the widely expected pause is likely upon us within the first quarter or so.  But by no means can we say that we have normalized anything yet, other than a shared penchant for a feckless political class.  For that we will need to see how profound a slowdown lies ahead – our view is that it is unlikely to be deep – while also factoring in the degree to which governments reign in their spend thrift ways.  With inflation now heading lower but remaining more elevated than the recent past we are unlikely to see significant cuts in the subsequent easing cycle unless the employment situation significantly deteriorates.  And assuming we have no external shocks (see 2020,2022…).

Factoring these considerations into market outlook we believe that earnings pressure will continue to rise on corporates and that valuations remain stretched in technology-related sectors, while financials will benefit from higher net interest margins and a more benign provisioning environment than is currently expected.  The wild card for bank equities is whether regulators increase the size of capital buffers or restrict capital repatriation in any way.  In December we saw some sign of that (ECB increased UniCredit’s Pillar II), but the scale of excess capitalization across the sector should prove more than sufficient.  While government bond markets have also moved to price in a slowdown with curves at extreme negative spreads credit securities have been slower to react which has resulted in increased risk premiums, making credit the most interesting asset class in the financial sector.

And so we approach 2023 well positioned for what we believe will be a significant opportunity.  The past few months we have been shifting the portfolio into securities with more upside in the upcoming market environment, starting move away from a defensive posture.  We have retained considerable dry powder however as we are likely to see disappointment that inevitably comes at the end of tightening cycles, as markets get ahead of themselves in pricing a more benign environment.   With inflation likely having peaked, our focus remains on earnings and employment data, which could both presage a more pronounced shift in direction.

In December the fund’s A shares were up 2.54% with credit contributing +208bps in gross performance and equities +51bps.  For the year A shares were down 10.0%, a disappointing result somewhat mitigated by Q4 performance.  Bring on 2023.