Overview
After a very challenging 2021 we had hoped for a more stable backdrop for 2022, but one thing we have learned over recent years is to expect shocks and surprises. At the beginning of the year, policymakers still expected inflation to be ‘transitory’ and commentators and economists expected a contained, if modest post pandemic recovery for the UK economy. Yet what followed was a year dominated by top-down macro factors rather than bottom-up company fundamentals. Russia’s invasion of Ukraine, together with the very hawkish pivot of central banks in the US and the UK, meant that any hopes for a controlled recovery from the pandemic were no longer a reality. Markets suffered a number of macroeconomic shocks, most notably the return of inflation and an end to years of record low interest rates. Large increases in the prices of food and energy sparked fears about a ‘cost of living’ crisis and declines in household disposable incomes. For businesses, investors worried that inflation would result in higher input costs and potentially lower profit margins leading to a reduction in company earnings.
In October, analysts delivered the highest proportion of downgrades since June 2020 and the divergence across the market cap bands was pronounced. The FTSE 100 recorded net upgrades thanks to the global dollar earners and energy constituents in the index. In contrast, the Mid 250 stocks suffered twice as many downgrades as upgrades. Global value stocks performed relatively well as investors rotated away from growth stocks and looked for opportunities among lowly valued, out of favour companies. To some extent, this shift could be seen as a reversal of pandemic trends, when internet and technology stocks were in demand. In terms of currencies, the US dollar was a standout performer, supported by higher interest rates in the US. The result was a UK market that was essentially divided into two camps.
The FTSE 100, with its large exposure to oil and gas, banks and mining companies was neutral for the year while the more domestically focused FTSE 250 and Numis Smaller Companies indices declined - 19.7% and -17.9% respectively. The UK also saw political change with Liz Truss’ appointment as Prime Minister and the disastrous budget from her Chancellor Kwazi Kwarteng which put further pressure on UK markets. We saw some stability as both Liz Truss and Chancellor Kwarteng were replaced by Rishi Sunak and Jeremy Hunt respectively, who reversed the actions of their predecessors. Equity capital markets came to a standstill in 2022 with very few IPOs in the year. We believe many IPOs scheduled for 2022 have only been postponed, not cancelled, and will come to the market eventually. Similarly, mergers and acquisitions (“M&A”) volumes have declined substantially, often driven by private equity firms deploying less capital than in previous years as well as challenges posed by the rising cost of debt. However, in the global M&A market, the UK was a hot spot of activity. Attracted by a cheap currency and many attractively valued assets, we saw two of the Company’s best performers come as a result of bids. The differing performance of the large and small cap indices was mirrored in fund flows. Large cap funds suffered small outflows in 2022 of c.2.0% of starting assets under management (“AUM”); mid-cap funds tracking the FTSE 250 saw outflows of 18.4% of starting AUM; whereas, Small cap funds saw outflows of 11.8% of starting AUM.
Equity markets were volatile in 2022 and, influenced by multiple exogenous forces, we saw irrational responses to news flow. In 2023, a recession seems inevitable. Central banks have stopped talking about a ‘soft landing' and the UK seems to be the first major market to accept that it has already entered a downturn. Even in a recession, there are still opportunities for the market. Stock picking becomes important, and our Quality Growth and Momentum process has historically performed relatively well against this backdrop.
Performance
The UK smaller companies sector as represented by the Numis Smaller Companies including AIM (excluding Investment Companies) Index delivered a total return of -17.9% in the year ended 31 December 2022. This compares with a NAV total return for the Company of -33.2%.
Over the same period the FTSE100 Index of the largest UK listed companies returned 4.6%. We thank shareholders for their support during a year of market turmoil. It has been impossible to deny that the year has not been painful for investors yet this is no reason to lose faith in holding investment trusts. The volatility for anyone who hasn’t lived through a bear market before must have been alarming but we remain resolute in the merits of our long established investment process over the long term, and indeed of the long term performance of smaller companies. Income focused mandates tend to be more value-orientated, as growth stocks tend not to pay out a dividend and our Quality Growth and Momentum process with income bias has not afforded the resilience of income mandates with that Value focus.
The Company’s underperformance was most keenly felt in the first half of the year where the market de rating did the most damage. This coincided with the most extreme period of value outperformance and lack of rationality within the market. The second half of the year saw an improvement in the market environment but there were still periods where there was a disconnect between fundamentals and share prices. It wasn’t until the final months of the year that the market began to reward Quality, yet Value remains as a positive contributor as well. The market also felt more rational in the final quarter of the year in its reaction to reporting results, which feels like a more manageable environment for us. Typically, market recoveries are characterised by cyclical value names leading the way, yet in the latter months of the year this was not the case. This gives us more comfort to look at each cycle uniquely, and not be overly led by the past. We believe there is potential for a market recovery during a recession and that, particularly given the sharp derating seen in Quality Growth names in the first half of 2022, this could be led by those resilient Growth businesses. Valuations are a consideration in our process.
Outlook
UK valuations have de-rated significantly and are at attractive levels relative to other regions. Within that, UK small and mid cap companies look very attractive relative to large caps, with the strong sector focus in the FTSE 100 Index combined with the “risk-off” trade driving significant divergence in index returns this year. The last couple of months has seen the market test some of these levels and we’ve seen a strong bounce in UK SMID cap stocks through October and November 2022.
With some more political stability in the UK, company valuations attractive relative to other geographies, and also a solid degree of overseas revenue exposure in the index, we are starting to see international investors look towards their UK allocations, which have been rock bottom for some time. We caveat this with some caution; there are still many areas of challenge including inflation, consumer squeeze, China supply uncertainty and many of these might be testing again over the winter period. We were not surprised to see markets decline in December 2022 and believe that may continue before we begin to see a more sustained recovery. Russia’s invasion of Ukraine remains an overhang for markets, particularly given its inflationary impacts, and for social and humanitarian reasons more than any, we would be pleased to see a peaceful resolution. At the time of writing, signals are pointing towards a shallower and perhaps shorter recession than many expected, and the Bank of England has also relaxed its degree of caution stated in November 2022.
In the UK we’ve seen strong reporting from retailers and travel businesses, providing some optimism that the UK consumer is not as cash strapped as the media might suggest.
The UK didn’t enter this cycle from peak earnings due to sentiment relating to Brexit and GDP growth relative to other regions over recent years. Therefore, there are reasons to believe UK earnings could be nearer troughs than other geographies, and that UK markets could recover earlier in this cycle than we have often seen historically. There could be a range of outcomes for 2023 and as uncertainty remains, we think our quality focus will prove relatively resilient.
In late 2022 there were broad areas of downgrades across the market, although there were, conversely, lots of areas of resilience and strength in the Company’s portfolio. This is due to our quality focus, as well as the companies in the portfolio being more selffulfilling in their growth strategies; which we believe is increasingly valuable when growth becomes scarcer. Lastly, with the derating of growth businesses seen throughout 2022, many of our quality growth businesses are trading on significantly lower valuations than historically and have been taking part strongly in the recent market recovery. This gives us some confidence in relative performance potential during a market recovery, At this early stage in the economic cycle, we continue to believe many cheaper value cyclical businesses will see earnings pressures over the short term; however, with sentiment low for many sectors in this space, a lighter recession may see share price strength amongst some areas.
The level of uncertainty continues into 2023; however, we expect a lot of the most painful changes in market conditions, seen in early 2022, are behind us. As such, we would hope for a more settled environment, where stock focus returns to markets, and share price returns are less dependent on top-down macro factors. Whilst inflation persists, more stabilisation in interest rate expectations has been observed, and the degree of macro surprise seems far less than in 2022, which we think is supportive for markets.