2022 was a watershed year for markets; here are the charts that tell the story.
Since the late 1990s, equities and bonds have mostly been negatively correlated, meaning when one was going down the other was going up, and vice-versa. When equities sold off, bonds usually bailed you out.
This has been tremendously valuable for investors and has been an underlying assumption in many portfolios. The regime shift to a higher and more volatile inflation environment broke that assumption.
The US stock market fell by 18% last year. With inflation coming in at more than 6%, this was a bad year for equity investors. But it wasn’t one of the worst – six have had poorer performance since 1926. What set 2022 apart was that long-term government bonds had their worst year ever at the same time, falling short of inflation by nearly 33%. A portfolio of 60% US equities and 40% long-term US government bonds would have underperformed inflation by 28% in 2022.
The sell-off in bonds has been driven by rising government bond yields (prices fall when yields rise) and credit spreads. The result is that bonds offer dramatically higher yields than a year ago.
Over 60% of the global investment grade corporate bond market now yields more than 5%. 12 months ago only a quarter of a percent did.
You can get around 5.5% on short-dated US investment grade corporate bonds. Yields would have to rise by a chunky 2% more to leave investors nursing losses. A year ago it would have taken only a 0.5% rise for the same outcome. This “margin of safety” against potential losses from future yield rises has risen dramatically.
For investors prepared to take on more risk, high yield is living up to its name for the first time in a long time, with a 9% yield. Hard currency emerging market debt is not far behind.
Bonds are back on many investors radars once again.
At one stage, nearly 30% of the global fixed income market offered investors a negative yield. The government bond market was the worst offenders; the proportion in this market exceeded 40% in August 2019. There were even high yield bonds trading on negative yields.
Investors who bought these and held them until they matured were guaranteed to get back less than they invested, at least in nominal terms. Many will give a sigh of relief that they have all but disappeared.
Many income investors have shunned bonds in favour of equities. It will be interesting to see if that reverses now that corporate bond yields comprehensively exceed dividend yields in many markets.
House prices may have been high relative to incomes in recent years, but low interest rates kept mortgage payments relatively affordable, even for those borrowing large amounts. The challenge hasn’t been the monthly payments, but getting hold of the deposit. With mortgage rates shooting up, that era is now behind us.
On a 2% mortgage rate, the monthly repayment on a £300,000 UK property bought with a 10% deposit and a 25 year repayment term would have been £1,144. At 6% it would be £1,740, more than 50% more. Potential homebuyers need to either find more cash, lower their expectations, or prices have to fall.
Very approximately, it would take around a 30% price decline in the example above for the monthly payments to be similar to before.
Existing homeowners are not as immediately impacted, on the whole. Fixed rate mortgages have grown as share of the total mortgage debt outstanding in the UK, and overwhelmingly dominate in the US. Higher interest rates will only have an impact when they need to refinance or move home. But, unlike in the US where mortgages are fixed for 30 years, UK fixed terms are usually only two to five years. There is breathing space but it is more time-limited.
Having been one of the worst performers for most of the past decade, the UK came out head and shoulders above the rest in 2022, with the US dropping towards the bottom of the leader board.
Even if 2022 disappointed when it came to the diversification benefits of holding equities and bonds, it highlighted the value of diversifying within equity portfolios. Many of the trends which had been in place in equity markets since the pandemic (and earlier) reversed course. Investors had also, in many cases unwittingly, taken on outsized bets that they would continue.
The US is nearly 70% of the global developed stock market and the US market had, until recently, become increasingly concentrated in mega-cap growth companies. When growth stocks took a tumble, the US took a tumble, And when the US took a tumble, global portfolios were highly exposed.
But concentration is not just a US feature. Five companies make up more than a third of the UK market and just ten make up more than half. Within emerging markets, the large three Asian markets of China, Korea and Taiwan make up 57% of that market. At one stage in late 2020 this was as high as 67%, when China alone made up 43% (currently 32%).
It is very important for investors to understand the concentrated exposures they are taking on when allocating to broad market indices. This could be in terms of stock, sector, style, or region. Achieving balance and diversification is, sadly, not as simple as investing in a portfolio of global stocks.
Our analysis of the text of US companies’ earnings reports (above) highlights a striking increase in firms’ talk of “reshoring”. Companies are planning on diversifying their production – and relocating it nearer to home.
This means one of the great deflationary forces of recent decades, the growth of low-cost production in China, is weakening and may have run its course. Globalisation can still play a role in lowering costs as production moves to new countries, but the easy gains are over as firms place increasing weight on security of supply.
The Russia-Ukraine conflict brought on a major global energy crisis. Prices rocketed as Russian supply came under sanctions. This has inflicted financial pain on many households and businesses, with Europe at the epicentre.
However, another, more positive, consequence has been an acceleration in the planned pace of renewable energy expansion. Already benefiting from the tailwinds of the global energy transition, High fossil fuel prices have further improved the economic appeal of renewable energy. And Europe in particular has sought to untether itself from its historical dependency on imported Russian gas. Energy security has become a bigger priority. This further supports demand for domestic sources of energy, with renewables to play a major role. In some cases, there will also be an expansion of domestic fossil fuel capacity e.g. coal mines in Germany are being brought back on stream and planning consent has been given for a new coal mine in the UK. However, this has not dimmed the ambition of the plans for renewables, which have shown to be clean, secure and not commodity linked.
Compared with what was predicted a year earlier, there has been an almost 30% uplift in what is forecast for global renewable energy capacity in 2027. This would result in a nearly 75% increase in global capacity between 2022 and 2027. According to the IEA, “China, Europe, the United States and India are implementing existing policies, regulatory and market reforms and new policies more quickly than expected to combat the energy crisis”. China is now expected to hit its 2030 targets for wind and solar by 2025. Implementation challenges are not to be downplayed but, driven by necessity, 2022 has been a transformative year for plans for renewables role in delivering energy security.
We will be publishing a series of papers in the first quarter on the regime shift that is underway. The first, an overview of what we regard as the five most important macroeconomic trends behind this shift, is available here. Upcoming research will dive deeper into each of the individual trends, and the investment implications.