Interest rates: Will the Bank of England get inflation under control and ease up on hikes next year
War in Ukraine, inflation and rate hikes have dominated a difficult year for UK markets. With a recession now looming, prospects for 2023 do not look immediately favourable either.
Investing experts are nevertheless hopeful that central banks will ease up on interest rate hikes next year, ideally due to inflation being brought under control rather than a nastier than expected economic contraction.
They also point out that the UK market remains cheap and unloved – international investors are apparently unreconciled to Brexit and the fallout for our firms’ ability to trade – although it has been one of the better global performers in a difficult year.
That means the UK continues to offer a good buying opportunity, especially if value stocks and income generating businesses are coming back into fashion.
The blue chip FTSE 100, where earnings are mostly derived overseas, is up 1 per cent on the year at the time of writing. But on the home front, the domestically-oriented FTSE 250 index has lost 19 per cent of its value, and the FTSE All Share is down 3 per cent.
Meanwhile, financial pundits note that the bond market crash was one of biggest investment stories of 2022.
Interest rate rises were already depressing bond prices, creating heavy losses for existing investors, when the UK Government bond market received a further self-inflicted blow from the Liz Truss regime’s disastrous mini-Budget.
For those on the lookout for decent deals, that debacle has helped make bonds worth a look again after many years when they were over-priced.
We round up views from investment industry experts on where UK equity and bond markets are heading next, and some fund and share tips for the coming year below.
Inflation: Rate hikes likely to ease as central bankers try to avoid crashing economy
‘The main source of pain in 2022 was arguably the persistence of eye-watering inflation, which had a knock-on effect on monetary policy and economic activity,’ says Janet Mui, head of market analysis at RBC Brewin Dolphin.
‘The good news is that inflation is likely to slow sharply in 2023 for a number of reasons.
Inflation of goods and services typically eases as demand falters in a recession. So, once inflation comes down, we can anticipate better times ahead
Janet Mui, RBC Brewin Dolphin
‘Commodity prices, including wholesale oil and gas, have fallen notably. Inventories of goods are building up and shipping costs are falling rapidly, which are good signs for price pressures to fall.
‘Historically, interest rate rises impact the real economy and inflation, with a lag of 12 to 18 months. Inflation of goods and services typically eases as demand falters in a recession. So, once inflation comes down, we can anticipate better times ahead.’
Mui adds that the bulk of large and rapid rate increases are likely to be over in major developed economies, and predicts the UK interest rate – currently at 3.5 per cent – will peak at around 4.5 per cent.
Central bankers are determined to fight inflation, but don’t want to overtighten and crash the economy unnecessarily, she points out.
‘Whether interest rates will be cut in 2023 depends on how quickly inflation comes down. At a best guess, interest rates will plateau and stay high, and cuts are more likely a 2024 story.’
Ben Yearsley, investment director at Shore Financial Planning, says: ‘I thought inflation would be transitory and frankly I’ve been totally wrong on that.
‘I assumed the Covid backlog would wash through the system fairly quickly but that combined with the effects of Russia’s invasion of Ukraine has prolonged the problem.’
But Yearsley says it feels as if we are at or have passed the peak of inflation, if you look at petrol prices or Drewry’s World Container Index and find prices have stabilised or are falling.
He nevertheless notes: ‘Wage inflation is now the worry for central banks as employment remains high – replacing workers isn’t easy. If wage inflation takes off, interest rates will have to go higher to dampen demand.
‘Ultimately inflation is at the centre of investment markets. For what it’s worth I do think by this time next year inflation will be much lower than today both here and the US.’
Yearsley says the depth of recession in the UK will be key, adding: ‘Most people either think we are in one already or are about to enter one, therefore adapt their behaviour and spending accordingly.
‘A shallow recession means rates will stay higher for longer, a deep recession will mean cuts are on the cards probably before summer.’
Investments: Sentiment is ‘incredibly weak’ so expect a bumpy road ahead
Aggressive rate cuts have abruptly yanked the world out of a prolonged period of ultra-low borrowing costs, which had been supportive of financial markets since the global financial crisis in 2008, says Bestinvest managing director Jason Hollands.
‘Unsurprisingly this has been ill-received by the markets with both equities and bonds sliding in tandem.
‘One manifestation in this reversal of fortunes is that the UK market has been one of the best performers this year, with UK larger companies – those in the FTSE 100 – set to beat the calendar returns of the S&P 500 Index of US companies for only the second time in 13 years.’
Top stocks of 2022: The FTSE 100 has remained resilient in the face of global headwinds, but some stocks have fared better than others
Hollands says the UK’s blue-chip index has benefited from high exposure to energy and defensive sectors such as healthcare and consumer staples, and minimal exposure to technology stocks.
But he goes on: ‘Ironically, UK equity funds have seen massive outflows by investors this year, likely a result of investors being spooked by gloomy forecasts for the UK domestic economy and political events.
‘Company earnings overall actually held up quite well during 2022, so the slide in equity markets during the year has primarily reflected a revaluation of companies to more reasonable levels rather than a deterioration in their profitability. Investor sentiment is now incredibly weak.
‘Investors should still expect a bumpy road ahead as attention increasingly moves on from inflation to the prospect of recessions in the UK, much of Europe and the US caused by tougher financial conditions are felt.’
Hollands suggests investors therefore take a relatively defensive stance, avoiding businesses highly vulnerable to a downturn like retail, leisure and property, and focusing on those with robust balance sheets, high recurring revenues and strong pricing power.
‘We continue to favour large UK-listed companies with international earnings. Valuations of FTSE 100 companies are incredibly cheap compared to their longer-term average valuations and other markets and it offers the highest dividend yield globally.’
Likewise, Mui says RBC Brewin Dolphin’s preference remains quality companies with strong balance sheets, pricing power, and sustainable business models.
She warns weak growth and earnings could drag the market lower before decisive rate cuts help equities bottom.
‘Throughout history, equities tend to deliver superior long-term returns. Timing the market is difficult, but the declines in prices we have seen this year give investors the ability to buy good companies at more attractive valuations.’
Meanwhile, Yearsley reckons investors will start to realise the value of good quality long term income streams and start to progressively buy into UK PLC again.
‘The UK is unloved and dare I say it cheap as it’s effectively de-rated this year. With no sign of a return to the tech mania of the last decade and things like dividends being seen as important again, the UK is well placed.
‘Versus the rest of the world, the UK looks to be 39 per cent cheap – having de-rated massively since 2016. On other measures it isn’t so cheap, but has still relatively fallen.’
What happened to bonds in 2022?
A sharp sell-off in UK bond markets left many investors sitting on heavy losses.
As central banks hike interest rates the returns from bonds, known as their yields, have to increase as well to keep luring buyers.
That makes the yields from older existing bonds look less attractive so investors dump them in a hurry, causing bond prices to plunge.
But rising yields make newer bonds look more attractive, particularly compared with usually riskier stock markets.
We explored investment opportunities after the bond price collapse here.
What about bonds? Higher yields are attracting buyers
‘The global bond market in 2022 will be remembered for being as challenging as it was in 1994,’ says Marion Le Morhedec, global head of fixed income at AXA Investment Managers.
‘Inflationary pressures fueled by geopolitical conflicts and imbalances between supply and demand led central banks to tighten their monetary policies abruptly and raise key rates.
‘The pace of the rate hikes was so fast, never before seen in the history of financial markets, that all asset classes were impacted. In September particularly, we saw a bond crash in the UK and extremely high volatility.’
But Le Morhedec says the outlook for 2023 is starting to brighten.
‘Firstly, the absolute level of yields is at its highest, which adds to the attractiveness of the bond market. Secondly, the central banks’ bull market cycle seems to be mostly behind us.
‘And finally, the rebound in performance observed at the end of 2022 is helping to restore investor confidence.’
She favours investment grade corporate bonds, and in terms of sectors real estate – especially logistics and residential – banks, and insurance via subordinated debt (unsecured debt, which is repaid behind more senior debt).
What is an inverted yield curve?
A ‘yield curve inversion’ signals unusual behaviour in the government bond markets, and is usually a harbinger of recession.
The inversion occurs when market players demand higher interest rates for loaning a country money in the short term than they will over the long term.
This breaks their usual practice of regarding debt that is going be repaid quickly as the safest and reflects a distinct lack of confidence in that country’s near-term economic health.
In more technical terms, what can happen is the yield or return from 2-year US government bonds – known as treasuries – gets higher than the yield from US 10-year bonds.
This is what market experts are talking about when they use jargon like ‘the 2-10 year inversion’.
Ben Yearsley, of Shore Financial Planning, says: ‘Government bond markets have been the story of 2022. At the turn of the year, the UK 10-year gilt yielded 0.97 per cent and the equivalent US treasury 1.51 per cent. Those yields today are 3.2 per cent and 3.61 per cent.
‘The UK obviously had a mini meltdown in gilts in the Autumn. The pain on the long end has been immense – the 2071 gilt had a high of £143, a low in September of £41 and is currently £61 – by the way gilts are “safe” investments!’
‘Yield curves inverting [see the box below] have been one of the year’s dominant themes and that’s still the case with the US two-year paying more than the 10-year.’
Yearsley admits: ‘I’ve hated bonds for much of the last 5-10 years – when rates are at zero where is the upside for fixed interest investments?’
But he adds: ‘When rates are at almost 4 per cent and still rising well, there is clearly plenty of potential.’
Yearsley says rates are now expected to peak at a lower level in the UK than previously thought and there could even be cuts in 2023, but the US is harder to call as it has less of an inflation problem and the economy still seems fine.
‘However you look at it though, corporate bonds (and indeed some Government bonds) look good value with yields available in excess of 6 per cent in many cases.
‘If you can lock into those levels for the medium to long term what isn’t to like especially as inflation should be down below 6 per cent by the end of 2023.
‘I’ve bought bonds for my Sipp for the first time since 2009 – to add some context I’m 46 and am an adventurous investor – though pragmatic might be a better term.’
What do investors expect in 2023?
Investor confidence is behind where it was in 2022 after a bruising year in the markets, says AJ Bell’s head of investment analysis Laith Khalaf.
‘Expectations for 2023 are neither bleak nor buoyant, with almost half saying they have a neutral outlook for their portfolio in the next year.
‘Although at the bottom end of the spectrum 17 per cent say they have a pessimistic outlook for their portfolio next year, up from 9 per cent this time in 2021.’
A Covid resurgence no longer worries investors, compared with 30 per cent who cited it as a concern this time last year, according to AJ Bell’s survey of 2,650 customers in December.
Inflation has now dislodged the virus as the biggest threat to investments, with 32 per cent citing it versus 26 per cent last year.
Investor poll: What is concerning you most about your investments for 2023?
Khalaf says: ‘Just 14 per cent of investors are forecasting a fall in the UK stock market in 2023. Although again that figure is higher than the 10 per cent forecasting a drop in UK shares a year ago.
‘Most expect market returns next year to be relatively flat or deliver a positive return of up to 10 per cent. Just 12 per cent think UK shares will return more than 10 per cent.’
How confident are you about the outlook for your portfolio in 2023?
Investment funds, trusts and stocks to watch
Financial experts offer tips on which investments might be worth a look in 2023.
Darius McDermott, managing director of FundCalibre
VT Downing Unique Opportunities (Ongoing charge: 0.89 per cent)
A fund’s third anniversary is a real milestone as it is deemed to be long enough to properly assess a manager’s skills, according to McDermott.
‘Launched in March 2020, this is a multi-cap UK equity fund run by the highly-experienced Rosemary Banyard.
What is an ongoing charge?
The ongoing charge is the investing industry’s standard measure of fund running costs.
The bigger it is, the costlier the fund is to run.
The ongoing charge figure can be found in the Key Investor Information Document (KIID) for any fund, usually on the top left of page two.
To track down these documents, put the fund name and ‘KIID’ together in an internet search engine.
‘It has a well-defined process looking for companies that have sustained competitive advantages, with low debt and good management teams.’
He notes: ‘Despite having a bias towards small and mid-caps, which have really suffered in recent times, the fund has so far returned 47 per cent for investors vs 52 per cent for the IA UK All Companies sector average.’
Unicorn UK Smaller Companies (Ongoing charge: 0.86 per cent)
One of the worst performing sectors in 2022 was IA UK Smaller Companies, with the average fund in this peer group making a loss of 25.7 per cent, says McDermott.
‘Managed by Simon Moon and Alex Game, this fund did relatively well last year, losing roughly 10 percentage points less than the sector average – placing it fifth out of 50 funds.
‘It’s a small, flexible fund with a solid investment process and a highly competent team. It is also quite concentrated, which allows it to capture the performance from its best ideas.’
Kate Marshall, lead investment analyst at Hargreaves Lansdown
Jupiter Income (Ongoing charge: 0.84 per cent)
This fund invests in companies the managers believe are undervalued by the wider market, says Marshall.
‘This style has struggled in recent years and means the fund can fall out of favour through certain periods of the market cycle.
‘The value investment style has the potential to do better when interest rates and inflation are rising, and the style came back into favour in 2022.
‘This isn’t a guide to future performance though. The manager invests in a fairly small number of companies, so each investment can influence performance for good or bad which can increase risk.’
She adds: ‘The fund’s charges are taken from capital, which could help boost the income but reduce some of the potential for growth.’
Investing in 2023: In a tough year, which investments might be worth backing?
Ben Yearsley, investment director at Shore Financial Planning
Montanaro UK Smaller Companies (Ongoing charge: 0.90 per cent)
Artemis UK Smaller Companies (Ongoing charge: 0.86 per cent)
Ninety One UK Equity Income (Ongoing charge: 0.84 per cent)
‘A massively oversold area is UK smaller companies. No one wants them, everyone hates them, which of course piques my interest,’ says Yearsley.
‘I could pick from almost any fund or trust in the sector, but I will highlight two. The first is a growth focused trust managed by a small cap specialist boutique, the latter can best be described as a GARP [Growth at a Reasonable Price] fund currently on a PE of 12.
‘The UK is generally oversold, and I think that could reverse as income, which the UK is good at, becomes more important. Ninety One UK Equity Income is my suggestion in this area.’
Rob Burgeman, senior investment manager at RBC Brewin Dolphin
Persimmon: ‘Some sectors in the UK market have had a really bad six to nine months – but they have strong businesses within them that are not going to go bust. Housebuilding is one of them, and Persimmon still looks like the blue chip option in the industry.
‘Despite the recent change in dividend policy it is likely to yield at least 6 per cent, assuming the share price remains around the same. But don’t bank on this for the dividend alone.
‘The UK still has a structural shortage of houses and there are still plenty of buyers out there – they just can’t get themselves a mortgage. I wouldn’t necessarily rush out and buy it today, but for the longer term there are worse things to own.’
Next: Burgeman says it’s difficult to be too optimistic about UK retailers at the moment, but Next is one of the stand-outs that can weather a tough period.
‘The retailer has been steadily buying up brand names that have gone to the wall in recent months, including Made.com and Joules.
‘Its online offering has never had so much choice of third party brands and this will place Next well for the upturn to come.’
Watches of Switzerland:’When asked about the impact of recession on its customer base, the CEO of a doorstep lender once quipped that it was ‘always a recession’ for them,’ says Burgeman.
‘The opposite is often true for those at the other end of the scale. Watches of Switzerland is a purveyor of luxury watch brands, for which there is always demand from well-heeled clientele.
‘The brands control supply so closely that there is almost always a queue of customers at any given time, however things fare.’