Market Review

Global equities whipsawed throughout December. Initially stocks rebounded from the sharp sell-off at the end of November, before the prospect of central-bank tightening and fears over Omicron’s impact sparked considerable volatility. While the new variant is highly contagious, a growing body of evidence suggests it causes less severe disease. The uncertainty caused a rotation out of popular growth and cyclical stocks and into defensive sectors such as health care, consumer staples and utilities.

Inflation continued to accelerate and central banks finally took steps to wind down their pandemic-related stimulus measures. The UK and Norway raised interest rates and a raft of emerging markets also increased rates during the month. In the US, the Federal Reserve pledged to accelerate the tapering of its bond-purchase programme, and expectations are that it may raise interest rates three times in 2022.

In commodities, Brent crude initially fell as traders expected Omicron to impact short-term demand, however by the end of the month Brent crude had rallied back to USD80. Natural gas prices saw extreme volatility, even hitting all-time highs in some countries such as the UK, as supply remained constrained against a backdrop of strong demand.

Portfolio Review

The Trust’s equity portfolio outperformed its benchmark in December, delivering a NAV total return of 5.2% vs the benchmark’s 2.8%. Stock selection continues to be the main driver of relative returns, with our balanced approach helping to weather recent market shifts.

At a single stock level, Unitedhealth Group made a strong positive contribution. Shares in the US health insurer continued to provide strong defensive growth thanks to the rising non-cyclical demand for managed health care. Membership continues to increase, thanks to both government and commercial contracts, with 2022 guidance looking increasingly conservative.

Abbvie also boosted returns. Shares in the pharmaceutical company have strengthened partly due to the rotation towards defensive companies, but also increasing visibility on growth after the 2023 Humira patent cliff. Recent results suggest that, following the Allergan merger, Humira accounts for less than 40% of sales, while Rinvoq (an anti-inflammatory) and Skyrizi (a treatment for Crohns disease) are beating expectations. The shares remain relatively lowly valued on circa. 11x forward earnings, with a well-covered dividend yield of over 4%.

AIA Group made the largest negative contribution to returns. Shares in the Hong Kong based provider of financial services faced continued pressure due to concerns around the health of the Chinese economy, political interference, as well as resurgent Covid rates. However, these near-term risks have overshadowed AIA’s historic ability to deliver double digit growth, driven by favourable long term demographic trends.

Partners Group also weakened performance. The private equity group has a strong track record of fee-based revenue growth. However, expectations for higher rates have seen investors rotate into financial stocks with greater exposure to net interest margins. Higher rates may also impact asset prices, denting fee expectations in the medium-term. We reduced the Trust’s position earlier in the year due to an elevated valuation but remain optimistic on the long-term investment case.

Market Outlook

The first weeks of 2022 have brought another sharp rotation into value stocks. A recent inflation print from the United States came in above 7%, a level not seen in over 40 years. With energy and labour costs continuing to fuel inflation and the Omicron variant apparently causing less economic damage than initially expected, the Federal Reserve has indicated it intends to tighten monetary policy faster than expected. Higher interest rates reduce the value of cash flows further out in the future, causing investors to sell highly valued stocks in favour of cheaper more cyclical companies. The immediate beneficiaries of this are commodity producers such as oil companies that are seeing their selling prices rise and traditional banks which benefit from higher interest rates. At the other end of the spectrum, highly valued growth stocks with long-distant future cash flows are seeing valuations de-rate.

Whilst there is some logic to these rotations, the market can often overreact and frequently fails to discriminate between different business models. As argued in previous notes, we believe quality at a reasonable price is the best defence against inflation. The ability to pass on cost increases is vitally important in an inflationary environment, especially one that persists for a sustained period of time. Inflation drives up operating and capital expenditure (capex) costs, eating into the capital base of companies. Our preference for companies with pricing power, combined with a valuation discipline that keeps us away from the extremes of valuation excess, makes the Trust well positioned for this environment. Similarly, maintaining a balanced and globally diversified approach that includes both cyclical and defensive companies will enable us to capture some of the upside as the economic cycle progresses.