How will public and private markets fare in 2023?
2022 was a tough year for public equity markets, especially UK small and mid (“SMID”) caps. Amidst a...
From the war in Ukraine to the cost-of-living crisis, stock market falls and mortgage rate rises, there has been plenty to worry about in 2022.
With Halloween just around the corner, we asked the managers of six Elite Rated funds what is keeping them awake at night when it comes to our investments.
“This year there is no shortage of scary charts on the bond market, with the 10-year gilt yield residing firmly in bear market territory. But what keeps me awake at night is the repercussion of the cost of funds for companies.
“While investment grade companies have resilient cash flows and have been prudent in extending their debt maturities, refinancing risk is terrifyingly greater in high yield. Cost of funds skyrocketed throughout the year, giving nightmares to Treasury teams. And, if these scary moves continue, the new issue market in high yield is likely to be like a ghost town in 2023.”
“As you (or your child) run from house-to-house trick or treating, kitted out with vampire teeth and maybe a fake knife through the head, carrying a large pumpkin to fill with sweets, spare a thought for what happens to all this plastic. In the last 20 years, plastic production globally has doubled, according to the OECD. Of the 78 million tonnes of plastic for packaging produced annually, 75% ends up in the environment or in landfill; only 14% is collected for recycling. A true horror show.
“Yet if we drive a stake through the heart of this linear model and develop a more sophisticated materials recovery system, we can save valuable resources (8% of oil global oil production goes into making these plastics) and stop our oceans looking like a scary brew of plastic bag soup. Advanced Drainage Solutions and Genuit make plastic pipes with 50% recycled content – slaying the vampire of plastic waste.”
“Quantum mechanics is at the heart of a computing and communications revolution, paving way to frighteningly quick data analysis, simulations, optimisation problems and other calculations that require huge amounts of processing power.
“Some of these processes exploit the phenomenon of quantum entanglement, something Einstein called ‘spooky action at a distance’. In essence, two atoms become linked and able to exchange information no matter how far apart they are, shockingly contradicting his own special theory of relativity which led many scientists to disbelieve its existence.
“However, as most ghost hunters will tell you, just because you don’t believe in something, doesn’t mean it doesn’t exist! Quantum computing is indeed a real thing, accelerating at pace and is leading to some truly ground-breaking advances in technologies. The potential of its power in daily life really does keep me up at night.”
“My greatest concern is that European interest rates are rising too slowly, and this may be allowing inflation to become embedded. Continental Europe has a history of much lower inflation than the UK in the 1970s and 1980s. European economies have thus become less able to cope with long periods of raised interest rates and politicians tend to argue against higher interest rates.
“However, history tends to show that failing to raise rates early leaves you needing to raise them higher later. This could bring back all the arguments about the Eurozone and interest rates, which suit northern countries while not suiting the southern nations.”
“Quantitative tightening (QT) is due to start in earnest on the 1st November – just in time for Halloween! The Bank of England is scheduled to start a serious active sale programme of the assets it bought during quantitative easing (QE), which was a ‘treat’ for the holders of the assets and was a policy measure they had to undertake to stimulate the economy. It is now time for the ‘trick’. QE was stimulative, QT is designed to restrict growth. We believe QE increased inflation – therefore, via reducing the outstanding stock of money, QT will act as an inflation dampener.
“One of the potential side effects not mentioned in the Bank of England guide is the potential effect on sterling. The transmission mechanism of interest rate changes affecting currencies is a potential catalyst for FX moves. Another direct effect of QE/QT is that the excess supply of something reduces its value and vice-versa. We would therefore expect currencies where the central bank pursues QE to have weaker currencies, and currencies where the central bank implements QT to have stronger currencies.
“When all countries are printing or destroying money in unison then the effect is not noticeable. However, when one country is printing and the other is destroying its money, then the latter currency should be stronger. This explains the scary chart below.”
“Higher inflation and interest rates have stoked fear in the market this year. As bond yields have risen, so has the risk-free rate, required equity returns and the cost of capital. The fast-moving political landscape over the last few weeks saw UK market sentiment worsen, leading bond yields to soar even higher and equities to fall further.
“A Rishi Sunak/Jeremy Hunt pairing has improved the market’s confidence of a less scary fiscal outlook than under Truss/Kwarteng, and whilst bond yields have since moderated slightly, they still remain elevated.
“Despite the headlines, we continue to see material valuation opportunities in UK small and mid-caps, particularly those with international exposure and a dollar component to their earnings. Several of these companies are trading below their trough valuation multiples and are pricing in an overly pessimistic scenario despite having robust balance sheets and strong cash flows, making them particularly attractive to private equity firms. In the absence of take-outs, improved macro-economic sentiment and a stronger consumer are imperative for a sustained re-rating of the overall UK small and mid-cap space and a narrowing of the valuation discount relative to history”.
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