Investment Manager’s Report: Summary

Market Review

An unexpected monetary volte-face by policymakers amid persistently high inflation weighed on equity markets and valuations during the year. However, losses were more than offset by pronounced US Dollar strength which gained more than 12% on a trade-weighted basis and more than 9% against the British Pound (GBP). As a result, the MSCI All Country World index over the year to 30 April 2022 gained 4.3% in sterling terms, aided by a strong first half characterised by economic reopening, upward earnings revisions, and rampant M&A.

The strength of the US Dollar mirrored sharply higher US interest rate expectations following the revelation in November that the Fed no longer believed inflationary pressures were ‘transitory’. Energy prices likely played a part in driving this Fed Pivot as oil and commodity prices rose 79% and 54% respectively during the year. Higher risk-free rates (10-year US Treasury yields increasing from 1.6% to 2.9%) resulted in a much more challenging fiscal second half with negative headline returns failing to capture the magnitude of the correction experienced by the average stock. While the US, as measured by the S&P 500, gained 10.2% in sterling terms (and 0.2% in local terms), drawdowns were significantly greater elsewhere including Europe (Eurostoxx 600 +2.3%), Japan (Nikkei 225 -12.0%) and Asia ex-Japan (MSCI Asia ex-Japan -12.9%) [all in sterling terms]. Weakest performance was reserved for Chinese stocks (MSCI China -29.8%) where a deluge of regulatory changes and market unfriendly developments took their toll on investor sentiment and lockdowns in Shanghai towards period end reflected the challenge posed by the omicron variant to China’s zero- COVID policy.

Small-cap indices meaningfully underperformed during the year, with the Russell 2000 (small cap) declining 9.6% while the Russell 1000 (large-cap) advanced by +6.2% (both in sterling terms). Breadth also continued to deteriorate with just c.25% of NYSE stocks trading above their 200-day average at year-end, compared to 58% a year earlier.

The first half of the year saw markets grind higher amid economic reopening, positive earnings revisions, and record equity inflows. This was possible due to worldwide vaccination programmes that succeeded in breaking the link between COVID-19 infections and deaths. Economic recovery was most evident in consumption trends and in labour market strength, the US unemployment rate falling below 5% by September before returning to pre-COVID levels by year end. The recovery trajectory was complicated by waning fiscal stimulus and labour shortages, exacerbated by the combination of limited improvement in the labour participation rate and early retirement (aka the ‘Great Resignation’). However, the most significant headwind was commodity shortages and soaring energy prices with oil surpassing $80/barrel in November for the first time since 2014, while US producer prices rose 8.3% y/y in August, the largest year-on-year increase on record. The combination of shortages and a surfeit of freshly printed liquidity saw CPI increase 5% y/y in May – the fastest growth in consumer prices since August 2008. This led to the June FOMC ‘dot plot’ implying two rate hikes in 2023, up from zero in March, and, in October, the Fed signalled that it could begin scaling back asset purchases in November. However, equity markets were able to shrug off these negative developments largely due to the Fed maintaining its earlier ‘transitory’ stance and persistently negative real rates supporting equity multiples.

The emergence of the highly mutated Omicron variant in November was an inauspicious start to what proved a very challenging fiscal second half. In the same month, recently re-nominated Fed Chair Jerome Powell performed a remarkable pivot regarding inflation, declaring “it’s probably a good time to retire that word [transitory]”.

While the milder variant of COVID likely contributed to a “more hawkish variant of the Fed”, it was November’s CPI print (+6.5% y/y) – the highest reading since 1982 – that likely forced Powell’s hand. Hawkish monetary developments dominated the balance of the year, with the Fed first moving to double the pace of tapering in December. An inflation shock morphed into a rates shock as the release of FOMC minutes in January raised the spectre of rate hikes and quantitative tightening (QT) “sooner or at a faster pace than participants had earlier anticipated”.

The first US rate hike since 2018 was also delivered in March, three months after the UK became the first G7 economy to raise interest rates since the pandemic began. By the end of April, markets had priced in Fed Funds at 250bps having anticipated zero rate hikes little more than a year earlier, and 10-year US Treasury yields had backed up to 2.9%, almost doubling during the first four months of 2022. The persistence of inflationary pressures saw other central banks adopt more hawkish positions too, forcing rates higher.

Long-duration stocks felt the full force of this monetary about-turn with the earlier tremor in weaker, more speculative names turning into a full risk-off episode across high growth and long duration names. This was particularly true within small caps where growth stocks trailed value by more than 20% during the year.

In addition to the human tragedy associated with the invasion of Ukraine, the conflict added untimely upside pressure to inflation and downside risk to global growth forecasts. Reflecting the elevated risk of so-called ‘policy error’ (the Fed tightening against this most uncertain of backdrops) the two-year versus 10-year Treasury yield spread briefly inverted during March, something often seen as a precursor to a recession.

Technology Risks

As ever, there are multiple risks to our constructive mediumterm view. Many of these relate to macroeconomics (recession; inflation; war, and others) that are covered broadly elsewhere. In addition, we should highlight the risk to technology spending should CEO confidence meaningfully deteriorate. Despite survey results suggesting otherwise, there could be some risk to cloud spending should earlier-stage companies/unicorns spend less aggressively. Other ‘big picture’ risks include widespread component shortages and labour market tightness. Valuation is another risk because even after this atypical correction, technology stocks have retraced back to average, rather than cheap territory versus history. While earnings progress is expected to moderate this year, numbers look at risk of downward revision given the weaker global growth outlook and US Dollar strength while record technology margins could be challenged by soaring input prices, tight labour markets and/or reopening (as companies give up or reinvest some of their pandemic savings).

As we warned last year, a steeper yield curve (noticeably absent at present) is unlikely to prove good news for technology stocks. Regulation remains a key risk with events in China after the aborted IPO of Ant a salient reminder of regulatory risk. That said, we are comforted by the existence of due legal process in liberal democracies painfully absent elsewhere. However, we would not be surprised to see a resurgence in regulatory scrutiny in the US post-COVID. While legislation will not be easy to pass, restrictive legislation has already been proposed by members of both parties that focus on app stores, first party/third party seller conflicts and responsibility for content on internet platforms (revising Section 230). We expect ‘Big Tech’ and their natural monopolies to continue to invite scrutiny and the drumbeats in Washington to grow louder over the coming year ahead of key lawsuits slated for 2023.

Concentration Risk

In addition to market and sector specific risks, it would be remiss of us not to remind our shareholders about the concentration risk both within the Trust and the market cap weighted index around which we construct the portfolio. At the end of June, our three largest holdings – Microsoft, Apple and Alphabet – represented c.28.5% of our NAV and c.41.3% of our benchmark respectively. Five years ago, our top three positions (Alphabet, Apple and Microsoft) accounted for c.22% of NAV and c.30% of our benchmark. The higher concentration of both our portfolio and benchmark reflects the spectacular performance of a handful of stocks that captured the zeitgeist of this cycle. These are unique, nonfungible assets and their long-term success represents their dominance of their respective industries in an interconnected world where network effects are paramount, and the marginal cost of distribution is low. Their influence is not only felt within technology indices; at the end of June, the largest ten stocks (including these three) in the S&P 500 accounted for 28.0% of its market cap. While off recent highs, this level of concentration is commensurate with levels not seen since the early 1980s. Although this makes the portfolio (and indices) more sensitive to the performance of a few stocks, we are encouraged by the fact that the largest ten stocks also explained 29% of index earnings as at year end. Trading at/around a market multiple, these stocks dominate market cap indices because of their earnings progress, rather than because they sport outlandish valuations as was the case in the late 1990s. We are very comfortable moving materially underweight them should we become concerned about their growth or return prospects, or should we find more attractive risk-reward profiles elsewhere in the market.