2022 was an interesting year on financial markets to say the least. Over the years, we have become accustomed to volatility and falling stock prices, partly because the mood of the market verges on the pessimistic every so many years.
A crucial event in 2022 that prompted a reversal of sentiment was, of course, Russia’s invasion of Ukraine. All things considered, the impact on economic growth was limited, all the more so given that the Russian economy is not that large. However, the war did rock commodity markets, and in particular the global energy market. These rising energy prices were a driver of quickening inflation, which had already been rising since the summer of 2021. Moreover, inflation has exceeded circa 10% for the first time in 40 years. What made 2022 truly different, is the especially rapid, pronounced interest rate hike. Money no longer costs nothing. Money has a price again, for the first time in nearly 10 years.
To maintain their credibility as custodians of price stability, central banks around the world began to hike interest rates aggressively. The FED raised interest rates from 0.25% at the beginning of the year to the current 4.5%. The ECB raised its rates from -0.5% to 2%. Interest rates are expected to continue rising into 2023, but by the summer this cycle of rate hikes should be over.
What financial markets did in 2022 is digest these rate hikes by the FED and the ECB. This meant that the bond market turned in a terrible performance this year. In Europe, the 10-year term on government rates rose from -0.2% to +2.3%. In the United States, a similar move occurred with the 10-year government rate rising from 1.5% to 3.7%. This massive interest rate rise caused bond prices to fall by -15% to -20%. Stock markets have also had to digest these rate hikes, with share prices also falling by -15% and even -20%.
In other words, stocks and bonds declined at the same time in 2022, which is why this is such a special year. The only relief for euro investors came from the US dollar, which climbed in value against other currencies by +7%.
On the upside, our portfolios have held up relatively well in these difficult circumstances. Let’s not forget that 2021 was a very positive year for investors.
These declines significantly improve investor prospects compared to a year ago. It is easy to see why for bond investors. For the first time in years, expected returns for a bond portfolio are attractive once again. A diversified portfolio, with corporate bonds, can deliver an ongoing return that is well above 3% again.
But the outlook for equity investors is also better than it was a year ago. The profitability of the companies in which we have invested has also improved further in 2022. Consequently, our equity portfolio is much cheaper than it was a year ago because of stock prices falling. At the end of December 2022, we paid circa 15 times the profits of businesses. At the beginning of 2022, however, investors still paid circa 20 times the profits of businesses. For equity investors, this is also a relatively cheaper entry point and most probably a prospect of better times.
How do we respond to these changed interest rates and valuations in our investment policy?
- The main choices (asset allocation), which we discussed at length during the past year, remain the same. The combination of inflation-linked bonds and equities offers investors the best possible protection against inflation. The international diversification of our portfolios also offers protection against the difficult and vulnerable situation in which Europe finds itself.
- In terms of choice, i.e. the shares and bonds we buy (security selection), we work in the same way that we have been doing for over 30 years. The emphasis continues to be on our own homework, healthy balance sheets without too much debt, and the generation of strong free cash flow. As a result of this approach, we did not get our fingers burned in 2022 on cryptocurrencies, hypes, overpriced valuations, or companies that do not generate cash flow.
- The third pillar of our policy remains our active approach. In the face of continually fluctuating interest rates, volatile prices, and changing valuations, our consistent approach to these fascinating financial markets allows us to actively manage our portfolio on a continuous basis. Every day we take courageous and rational decisions, which, combined, contribute to a decent return on a long-term horizon.