Fiducia Balanced Portfolio Q4 2022

Market Perspective: 5 Building Blocks

• Our current economic outlook covers five key areas that, in our opinion, are all beginning to provide some comfort:

The Economy

• The worldwide recession figures don’t necessarily provide a uniform picture. As you would maybe expect, the EU scores are pretty low, with a recession looking ever more likely, however interestingly, the United States (US) scores remain strong, with Gross Domestic Product (GDP) still likely to continue to grow and having done so by 2.6% in Q3 2022; their position is surprisingly stronger than many expected. The same analysis is supportive of India, Vietnam, and Japan.
• Shipping container costs are now steadily coming down, they have come down from $12,000 to $3,000; not quite back to the pre-pandemic $2,000, but well on the way, as well as delivery times also improving significantly. From this, it appears that the supply pressures that had built up are now beginning to ease. To date, roughly between 2/3s and 3/4s of the inflation spike we have witnessed was due to supply side issues rather than demand side issues; now if these are reversing, as it appears, then those inflation pressures are likely to also ease back relatively quickly. However, it is important to note, the demand side is still an issue; unemployment is still low and is still yet to begin rising. Wage growth in the US is still at 6-7%, whilst also picking up in the UK. Therefore, this side of the inflation story is not yet going away and most likely will continue to get worse. However, job openings data is now falling, though much more in the US compared to the UK, which is slightly positive news. All in all, we can take some comfort that supply side indicators are much more positive than they have been for the last 2 years.

Energy Market

• In the energy market, we are slightly more comforted than we were at the beginning of Q3 when we last provided an update. When we released our previous update, we had expected OPEC+ to target $100 a barrel. As we’ve seen recently, they have again cut production, however, the supply target before the cut was 43 million barrels a day, but despite this, before making the cut they were only producing 39 million, so the fact that they have reduced the target by 2 million does not necessarily mean that there will be a reduction in production. Against a backdrop of an economic slowdown, it looks to us that we won’t now get to the $100 a barrel that was previously expected, though it may get close to that level.
• Looking at European inventories, they are now at full capacity, so the problem now is no longer adding to their inventory, but instead adding to capacity. This winter, even with cutbacks in certain areas, the outlook is looking more reassuring that it did a month or so ago. An implication we believe hasn’t been given enough attention is the fact that the subsidising package from the UK government, despite recent amendments has had a big impact in reducing energy bills, and market sensitivity to energy has reduced significantly, and we would go as far to say that, especially for the next few months, the worst is over. Clearly, there can be unforeseen acts of terrorism, with pipes being blown up, which could cause future issues, but in the UK specifically we are receiving more liquid gas supplies now than we would have done previously and so there are means of compensating against this possibility. This outlook provides another source of comfort for us.

Inflation

• Now, onto the inflation building block; core rates continue to rise across the world, even in Japan, which has probably come as a relief for them after decades of a deflationary environment! However, as mentioned previously, the supply side of those pressures seem to now be easing, and quite fast. It will not surprise us if we soon begin to see better inflation data coming through. It will depend on where you are in the world, but we expect inflation now to peak around 9-10%, and with the current instance of the UK, this had previously been looking more likely to peak at around 15%.
• Data that we tend to look at that is more relevant for markets is the 5-year forward looking inflation data; for the UK this is coming in at around 3-3.25%, and for the US something around 2.5%. So, the markets medium term forecasts are for inflation to fall from the peaks we are currently experiencing, but not all the way to the previous target of 2%. Though despite not reaching the previous target, inflation news should begin to get better sooner rather than later, a relief both politically and economically. We now predict it is likely to settle at 3-4% medium term, though how acceptable that would be to a central bank such as the Bank of England is another matter.

Central Bank Policy

• Moving onto policy; the one thing we have been concerned about for a while is people underestimating the impact of going from a Quantitative Easing (QE) environment, where central banks introduce new money into the money supply, to a Quantitative Tightening (QT) environment, where central banks remove money from financial markets to stem the dangers of an overheating economy. Over the last decade, with low interest rates and QE, there have been all kinds of anomalies that have been allowed to open up, or there were risks being taken that were allowed to continue for longer; examples of this have been Bitcoin or Leveraged Debt Instruments that were at the forefront of the recent UK pension fund crisis. However, the fact that we are still going into QT mode, both in the UK and elsewhere, central bank balance sheets will be falling in aggregate over the next 18 months, and so irrespective of what happens to interest rates, the ‘rug is being pulled’ from underneath of many financial structures that have been put in place during a period of low interest rates and QE, as was the case in recent weeks. We hope that ‘the light has now gone on’ and highlighted the weakness that is there in the system. The combination of this ‘eureka’ moment, along with inflation news hopefully now improving, should mean that interest rates shouldn’t need to go, and neither should they, to the levels previously talked about such as 5-6%, which should they reach this point, we think could be very dangerous. Anything beyond 4% risks increasing financial instability, and of course, central banks are not just there to fight inflation, but also to maintain financial stability. If interest rates do then ease of as we expect, and hope they do, this should again, provide comfort for markets.

Valuations

• The final building block; market valuations have clearly been adjusting for most of the year-to-date, however, in September they adjusted dramatically. We have seen real bond yields in the US go from –1.5% to +2%, and the important point to stress here is that most of the increase in bond yields that we have seen is not the inflation premium increasing but instead the real yield changing. On that basis, 2% real yields match liabilities without having to do any leveraging, though it would be nice if it was higher in the context of providing a risk premium, but it is certainly more reassuring than what we have seen for a while. We have also seen investment grade credit go from 2% to 6% within a matter of days. Then in equity markets, Price/Earnings ratios and valuations have come down significantly, with the US for example, now more in line with its historic average. This again provides some comfort to us that we may now be reaching an entry point to introduce some risk back into the portfolios and is encouraging for more risk taking.

Portfolio Positioning: Return of Risk?

• Following the five building blocks we assessed in the market perspective and the comfort we are now beginning to receive from them, the question we believe we now have to ask ourselves is; have the markets discounted the worst that can happen?
• Given that there are still uncertainties; Covid numbers are still going up, the Ukraine-Russia war continues to roar on, and the dollar is showing no signs of helping out where the markets are concerned, it is best to not set ourselves any specific further revaluation of any size, but instead, given we are not ‘bottom pickers’, a near on impossible feat, we are now looking at the situation and thinking whether now may be the time to ‘put a foot back in the water’? As long-term investors, should we not be taking advantage of the panic in markets that is currently occurring, rather than waiting for things to settle and then possibly being too late to get in.
• We believe that yes, we are now at that stage. Our Tactical Asset Allocation Questions (TAAQ) system, that predicts the probability of different outcomes from uncertain events, allows us to override emotion. Watching the news can make it difficult to do so, however, a disciplined approach does allow us to some degree to achieve this. Since the previous quarter the scores have changed quite significantly, and that is largely due to the valuations in the bond and equity markets changing significantly in that time. We have also seen large changes to the correlation between a lot of the asset classes to that of bonds and equities. For example, hedge funds, private equity, property, and infrastructure have all provided diversification against bonds and equities to the portfolios for a long time. However, with the changes we have seen in markets, the asset classes themselves have changed, and therefore their diversification benefits have changed, now having a far greater positive correlation to bonds and equities. In a number of these asset classes, we have had a very good run, such as private equity and infrastructure. The idea is that we can now tilt the portfolios the other way to a degree, and take some of the returns from these asset classes and recycle them into specific areas of the bond and equity markets.

Fiducia Investment Committee Positioning: Balanced Portfolio

• Cash: Our cash weighting remains overweight, which should continue to provide the portfolios with a necessary insurance policy in difficult markets, and the fire power to deploy the funds into assets should an appealing opportunity arise. The weighting remains at 6%.
• Bonds: Global Bonds have been upgraded to a neutral weighting. Certain areas of the bond market are now beginning to look appealing, particularly short-dated corporate bonds. Following a recommendation from Asset-Intelligence, we have introduced L&G Short Dated Sterling Corporate Bond Index with a weighting of 3%. This simple, passively managed vehicle offers investors a way to access short-dated corporate bonds at low cost. Short-dated bonds are typically less volatile than their longer-dated counterparts, while their capital values are also less vulnerable to rising interest rates – certainly a relevant characteristic at present.
• Hedge Funds: Hedge funds have been downgraded from overweight to neutral, they are no longer beating cash on a 12-month rolling basis, with their correlation to UK equities now above 0.5. The risks to hedge funds do still remain lower than bonds though. During the Investment Committee Meeting, it was highlighted by Michael Hughes that there was some tension appearing in the JPM team following a difficult year and the fund may now entering a difficult period of decline. With this in mind and following the tactical analysis highlighting that 4% should be taken from the Hedge Funds asset class, it seemed appropriate to remove the fund completely.
• Property: Property remains overweight, yields remain higher than that produced by equities and corporate bonds, with discounts in property investment trusts still greater than 10%. It is not the time to be removing exposure to property. Following advice from Asset-Intelligence, it was agreed to remove HSBC Global Property and replace it with the iShares passive tracker. The fund appears to be in decline, possibly terminally so. It had assets of almost £420m in February 2020 but is now down to less than a quarter of that figure, standing at £83.4m in size. A key part of the original rationale for the support of the fund was that it was a ‘hybrid’ vehicle, with a neutral position of 50% global property securities funds and 50% UK direct commercial property funds. This setup provided an appealing blend of liquidity and volatility lower than the equity market. However, in the wake of the liquidity issues suffered by direct commercial property vehicles in recent years, the fund has transitioned to being made up almost entirely of securities funds. Given this change we believe that a similar job could be done by a passive global property securities fund or a global REIT – and at lower cost. More broadly, the view here remains one of some concern as to the outlook for property given that we are not yet at ‘peak rates’. With this in mind, the iShares Developed Markets Property Yield ETF was chosen as a low-cost alternative that will track the global property market and has outperformed over 1,2,3, and 5-years.
• UK Equity: The UK equity market remains at a neutral weighting, although interest rates are low in relation to expected nominal income growth, growth over the next 1-2 years is not expected to be higher than inflation, and unemployment is not yet rising. We have added 1% to the UK equities asset class. The UK is looking very cheap generally, whether Growth, Neutral or Value, Large, Mid or Small. Nick Train, the fund manager of Finsbury Growth & Income Investment Trust, defensives have been out of fashion and in our view probably offer the benefit of being cheaper than they were, defensive in a recession environment, plus the growth stocks could be possible beneficiaries if and when the rate hikes are expected to stop and some respite for such plays occurs.
• Global Equity: Continued high inflation and labour pressures are weighing on the global markets outlook. US corporate earnings continue to hold up and GDP grew this quarter, though we are beginning to see profit margins squeezed in certain sectors. Following discussions in the Investment Committee Meeting it was agreed that in a balanced portfolio it was important to maintain a value tilt and not invest too heavily in growth stocks. Therefore, 2% was added to the Fidelity fund, which invests in high dividend stocks that are valued on current earnings.
• Global Emerging Equity: The outlook for Emerging Markets has improved slightly but still suffers many downside risks. Current valuations plus inflation are still less than 20, and appear attractive on a relative basis compared to the developed world, but our view remains neutral. Asset Intelligence have retained their conviction in the Fidelity Emerging Markets fund despite recent performance being negatively impacted by allocation to Russia, increased geopolitical tensions in Taiwan, and more recently overweight to Hong Kong. The under performance provided a good entry point for further allocation and so an extra 1% was allocated.
• Private Equity: Private Equity has downgraded to underweight from an overweight rating. The correlation of Private Equity to equity markets has now increased to 0.89 and is now providing less diversification to the portfolios. Following tactical analysis, it was suggested it was time to take some proceeds from the Private Equity asset class. As not to reduce any holdings to 1% and keep a diversified asset class with two holdings, it was agreed that Pantheon would be reduced by 1% and the HarbourVest Global Private Equity fund would be held at 2%.
• Infrastructure: Similarly to Private Equity, infrastructure has performed well on a 12-month rolling basis relative to other asset classes, including equities. With the asset classes correlation with equities now rising, some returns have been taken. To provide the weighting for the allocation elsewhere, it was time to reduce the holding in infrastructure following a good year-to-date. Following analysis by Asset-Intelligence, it was agreed to remove 3i Infrastructure and maintain the more diversified holdings of the Lazard and Foresight funds.
• Commodities: Commodities remains at a neutral weighting. The asset class continues to outperform equities significantly whilst providing a lower correlation than other asset classes and therefore providing some diversification within the portfolio from equities and bonds. No adjustments were made to this asset class during this quarter.

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