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Cirilium monthly commentary - April 2022

Date: 26 May 2022

Market review

Equity and bond markets fell in April as investors fretted over the ongoing course of interest-rate rises and the expanding economic consequences of the war in Ukraine.

With central banks wrestling to bring record levels of inflation under control while reducing their support for financial markets (by ‘shrinking’ their balance sheets) and an energy crisis raging, the outlook for growth soured.

This saw the marked rotation into more defensive ‘value’ stocks (which pay high dividends) and away from ‘growth’ stocks, continue in April; the MSCI World Growth Index plummeted 7.6% while the MSCI World Value Index was down just 0.3%.

Due to its bias toward growth companies, the MSCI USA Index was the worst-performing regional equity market in April, down 4.6%. Its heavy weighting to technology stocks was costly in a month when the MSCI Information Technology Index was down more than 7.5%.

A sharp sell-off in ‘growth’ stocks weighed on the higher-risk portfolios

Meanwhile, US annual inflation reached a 40-year high of 8.5% in March. In the UK, the Consumer Prices Index (CPI) rose by 7% from a year earlier. The sharp rise in western inflation had been stoked by increased demand as economies come out of lockdown, an ongoing energy crisis and renewed lockdowns in China due to its ‘zero-covid’ policy.

Elsewhere, the UK equity market’s extensive weighting to energy stocks was a major positive for the local indices as was its sizeable exposure to more defensive sectors such as consumer staple and healthcare stocks. This helped the UK indices to deliver small positive returns with the FTSE 100 Index gaining 0.8% while the broader FTSE All-Share nudged up 0.3%.

European equities lost further ground but notably outperformed the US market. Recent corporate earnings releases have generally been better than expected, helping temper negative investor sentiment as the knock-on consequences of the sanctions on Russia are expected to hit the region particularly hard. Consequently, the MSCI Europe ex UK Index declined by 1.7%.

In bond markets, the rapid sell-off continued in April. The suggestion of 0.75% interest-rate hikes from one US Federal Reserve (Fed) board member caused panic while expectationsalso grew for the European Central Bank (ECB) to cease its bond-buying programme over the summer and begin raising interest rates.

Corporate bonds declined more than US Treasuries with the Bloomberg Global Aggregate Corporate Index (sterling hedged) falling 4.4% in April while the Bloomberg Global Aggregate Government Treasuries Index (sterling hedged) declined 2.3%.

In currencies, the Fed’s commitment to reining-in inflation with interest-rate rises, coupled with the broader risk aversion sweeping financial markets, buoyed the US dollar. It strengthened around 4.5% versus sterling.

The weakness of the Japanese yen this year also remains a major story. Despite the significant recent weakness of sterling, the yen is still more than 5% down against the pound since the start of March, when its rapid depreciation began. Consequently, although the MSCI Japan Index retreated 4.4% for sterling investors in April, around half of this loss was the result of the yen’s painful decline.

(All performance figures in sterling terms and rounded to one Continued on next page decimal point, unless otherwise stated.)

Note:Currency hedging of foreign investments dampens the effect of currency fluctuations on returns and reduces the volatility of your investment. Under most circumstances, we currency hedge foreign currency bond holdings except in cases where the foreign currency exposure is an explicit return-driver (eg emerging market local-currency debt exposures).

Performance review

With global equity and bond markets in full retreat during April the Cirilium portfolio range posted a negative return for the month. While Cirilium Conservative outperformed its Investment Association (IA) sector comparator, the higher-risk portfolios were weaker than their respective peer groups. This can be attributed to a sharper sell-off in ‘growth’ stocks that were more sensitive to changes in investor sentiment.

We have long sought to avoid speculative excess and/or non-profitable companies that promise great riches, but the reversal in sentiment was much broader and harsher than we would have expected.

Equities were responsible for much of the decline over the month, and it was managers with a bias towards growth, quality, and small and mid-cap stocks that saw the weakest performance during the month.

Equities were the biggest detractor, especially quality, growth and small/mid-caps

This included the Granahan US SMID Select, Montanaro Better World and Sands Global Leaders funds, although it is more of a reflection of weakening sentiment than it is a barrage of poor results. All three managers have strong long-term track records, but regrettably all performed poorly in April and for the year-to-date. We have not identified a breakdown in their investment process, and we continue to favour investing in growing businesses with pricing power, but short-term performance has nevertheless been disappointing.

Berkshire Hathaway was also a detractor during the month, with performance broadly in-line with the US market, although it remains in positive territory for the year-to-date.

There were some positive contributors, however, with the Quilter Investors Equity 2 Fund, managed by Ninety One, the River & Mercantile European Fund, and Riverstone Energy among the standout performers.

Within the fixed-income space we have benefited from the decision to have lower interest rate sensitivity in the portfolio, especially when expectations for rate hikes move so quickly. Among the detractors were three of our strategic bond managers who had started to increase their interest rate sensitivity in anticipation of slowing growth, but which with hindsight was a little too early. This included the Allianz Strategic Bond, Janus Henderson Strategic Bond and Wellington Opportunistic Fixed Income funds.

However, the Jupiter Strategic Absolute Return Bond Fund bucked this trend in Cirilium Conservative and Balanced, while the higher yield offered by the Fair Oaks Income Fund provided some insulation to the Cirilium Conservative and Dynamic portfolios.

Investment activity in the month largely focused on general portfolio management and manager rebalancing.

Following a series of manager meetings, we locked in gains from some of the holdings that had performed well and recycled the proceeds into some of those that have been weaker and provided a good buying opportunity. This included adding to the Granahan US SMID, Montanaro Better World and Sands Global Leaders funds, and reducing our exposure to Berkshire Hathaway, Harbourvest Global Private Equity and the Ninety-One Global Special Situations Fund, amongst others.

In terms of our fixed-income holdings, towards the end of the month we began increasing the interest rate sensitivity through the addition of US bond futures, which was funded by reducing and/or selling the Allianz Fixed Income Macro, HSBC Ultra Short Duration and Janus Henderson Absolute Fixed Income funds.

Outlook

We had started the year with much promise of a return to normality following two years of pandemic-related disruption, and the global economy, while slowing, continued to enjoy strong tailwinds. However, while robust labour markets and substantial pent-up savings remain supportive, risks to the broader recovery are building. Central bankers face substantial challenges as they look to tighten monetary policy to help bring inflation back down to target without tipping their respective economies into recession. Furthermore, aside from the humanitarian crisis, Russia’s invasion of Ukraine is adding to the central banks’ challenge through high (inflationary) commodity prices.

With so much near-term uncertainty, rather than being blindsided by an arbitrary decline in percentage terms, it is important to focus on what financial markets reveal about expectations for the future. Simply put, is a sufficiently ugly scenario already priced into asset markets to set the stage for a potential recovery?

Lower sensitivity to interest rate changes helped our fixed-income holdings

The question is best answered though fundamental analysis, which for us also includes a thorough analysis of our underlying managers, their portfolios, and their thinking. This certainly helps us to understand what is happening in financial markets versus what is happening in the real economy.

Consumers, business leaders, investors and government policymakers face several legitimate concerns, including inflation, tighter financial conditions, slower growth, and potential recession. But asset prices have already fallen, and volatility has already risen. Valuations are much less extreme than they were and, in some cases, reflect embedded expectations that are quite bleak. It may feel more comfortable investing when the consensus outlook is for sunshine, but the best returns often follow an environment that is far less cheerful.

Against this backdrop, we strongly believe in the case for diversification, active management, and patience rather than trying to speculate on the most appropriate short-term factor or planning for a binary outcome. Looking forward, it will be more important to identify companies that can maintain healthy margins thanks to strong pricing power rather than whether growth will outperform value, or vice versa. In fixed income, there is finally a case for adding duration, although with central banks playing tough it will be important to remain nimble and invest opportunistically.

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Paul Craig

Portfolio Manager

Hinesh Patel

Portfolio Manager

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