The first half of 2023, whilst being
punctuated by a banking crisis and the associated volatility (sic) that comes
with one, has been an incredibly rewarding time for risk assets.

After the struggles of 2022, equities in
general have enjoyed a period of supernormal returns, buoyed by central banks
finding ways to loosen policy whilst rates remain elevated; ‘not QE, QE’,
whilst in Japan there has not yet been any tightening at all; ‘don’t fight the
Fed’ et al. As one would expect, as conditions loosened and the lagged effects
of higher rates are yet to be truly felt, there has also been a significant
rotation back to growth from value which can be seen clearly by the relative
fortunes of the value-heavy UK 100 against its growth-dominated counterpart in
the US this year.

Once more the outlier in global equities
was China / Hong Kong, where idiosyncratic issues continue to temper sentiment
as the initial optimism over the country’s reopening fades.

In a quarter of continued positive
performance for most of the Fund’s underlying indices, the Fund posted a
positive return of 2.3%.

Given the moves down in the underlying
indices to which the Fund is exposed during 2022, the number of investments
maturing early had reduced significantly. But, as the recovery has gathered
pace, those indices have begun to satisfy their early barriers once more.
During the quarter, 10 investments observed; the first eight had at least one
index below the required hurdle to mature early, before the two investments
that observed later in June called.  

As a reminder to investors, every
investment in the Fund must have its final barriers both to protect capital and
achieve full capital growth in the 60s at most; in other words, for every
investment in the Fund, the underlying indices can fall more than 30% (often
closer to 40% and in some cases even 50%) over a six year period before not paying full returns or
risking capital. Both investments that called, did so at the end of the second
year of their potential six
year
life, paying 14% (2 x 7%) and 12.6% (2 x 6.3%) respectively. They were replaced
with new investments with a potential return of 11.1% and 10.1% with lower
final barriers, illustrating just how attractive the pricing environment is
currently. With markets having enjoyed such a stellar run, barring a
significant fall in the very near future, there are a significant number of
investments set to mature early that have been offering returns almost half of
what can be achieved for commensurate or even lower risk today.

It is the current high rate environment which is mostly responsible
for the attractiveness in terms, a far cry from the middle of 2021, when the
investments that recently called were struck. At that time, the two main
pricing inputs of rates and volatility were very low, meaning that unless one
was willing to assume greater risk, one had to suffer a period of lower than average returns in order to not change the risk
profile of the Fund. This Fund will not deviate from its strict guidelines as
to its final barriers, irrespective of environment. The current environment has
meant that the Fund can maintain its already attractive GRY, whilst also
lowering the average barrier levels:

Equity markets finished the first quarter of 2023 as they started it; in buoyant mood.

However, as the dust settles on Q1 2023, it is likely to be remembered as an extraordinary one.

As we entered the year, headline inflation had been falling and data improving, causing markets to begin to price in a ‘no landing’ scenario and a return to loose monetary conditions much sooner than was previously forecast, to the benefit of risk assets across the board.

February saw some reversal as the ‘headwind’ of strong data surprises as well as a reacceleration in core inflation numbers forced investors to once more reassess both the terminal rate and more importantly how long rates may remain elevated for; the market was back to the 2022 scenario of bonds and equities struggling simultaneously.

The prospect of rates staying higher for longer caused some cracks to appear in the banking sector in March, albeit consigned to smaller banks that had a duration mismanagement / no management issue coupled with a concentration of potentially flighty deposits. In mid-March the market had a significant wobble followed by the extremely unusual scenario in which the bond market was pricing in a banking crisis whilst equity and credit were unmoved and latterly buoyant; the Fed put is back it would seem.

The quarter as a whole has been a very positive one for risk assets, and the 60/40 portfolio, as both bonds and equities recovered significantly, even with a mini crisis punctuating the period.

The Fund returned 0.3% during the month and 5.0% over the quarter.

One investment observed during the month without calling.

If there was any remaining doubt about the Federal Reserve’s impact on markets through the addition or subtraction of liquidity, then March should have put that to bed.

In a single week, the previous 18 months of QT was undone and the market was immediately willing to look through the cracks that had appeared in the system to resume an upward trajectory. In February’s commentary it was noted that ‘investors must get used to the fact that ‘higher for longer’ is likely to remain in place until either inflation does come back down to target, which is likely to prove difficult (ceteris paribus) given structural shifts in economies, or the Fed tighten enough to break something, as they always do.’  It remains to be seen whether in the Fed’s opinion they did break something, or whether they see the SVB issue as unsystematic. The unanimous vote to raise by another 25bps in the aftermath possibly points to the latter.

Either way, it remains unlikely that there will be a pivot in policy without the economy crying out for it, and whilst the labour market remains unusually tight given the economic backdrop, the Fed will be hesitant to use the monetary policy weapons in its arsenal to fight a battle that has not yet begun. The bond market in March priced in a crisis whilst equity and credit were ‘business as usual’; one must be wrong, and the Fund should be able to produce positive returns over the medium to long term in either scenario.

What a difference a month makes.

After January’s spectacular start, investor optimism was tempered in February as, having eschewed reassessing assumptions based on more positive economic data, investors were forced to take note of the reacceleration in core inflation numbers and reassess where both the peak rate of interest lies and how long rates may remain elevated relative to the ultra-low levels they have become accustomed to in the post-GFC world.

That reassessment of how close to the end of the global tightening cycle we lie caused global equities and bonds to sell-off in tandem once more. Chinese equities were particularly poor performers, after a strong start to the year, as geopolitical tensions overshadowed the continued reopening as various ‘spy balloons’ found their way onto foreign shores.

The Fund returned -0.4% in February.

Two investments observed during the month with one of those investments maturing.

The maturing investment, which was linked to the FTSE 100 & EuroStoxx 50, called at the end of the first year of its life, paying out its full return of 7.7%. The proceeds were reinvested in an investment linked to the Nikkei 225 & EuroStoxx 50, with an annual return of 8.9%, illustrating that terms remain attractive against the environment into which the Fund launched.

The opportunity was also taken to upsize positions with attractive GRYs on the back of inflows.

There is currently over 34% on average before capital is at risk, and over 32% before investments would not pay out their full growth amounts, unchanged from last month.

The Fund’s GRY increased to 10.4% in the event that the underlying equities are flat, and the Fund retains large amounts of intrinsic value.

Of the three scenarios that could play out this year:

• Soft landing (& now ‘no landing’)
• Hard landing
• Higher for longer

The market was increasingly confident at the start of the year that no landing, or at worst a soft landing, had been orchestrated simultaneously with inflation making its way back to target largely by supply chain easing given Fed policy cannot be overly restrictive without some form of landing.

However, recent data has called this assumption into question. For the first time in a long time, central banks have replenished some of the arrows in their quivers to tackle a recession as and when that happens. The idea that there would be a pivot and those arrows would be used before any landing is in sight is fanciful. Investors must get used to the fact that ‘higher for longer’ is likely to remain in place until either inflation does come back down to target, which is likely to prove difficult (ceteris paribus) given structural shifts in economies, or the Fed tighten enough to break something, as they always do. Either way, we are comforted by the protection afforded to investors in the Fund, and the significant returns it can produce in an environment in which equity struggles.