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Noise, babble, and lessons from history

Updated: May 22, 2023

It is important to assess the investment lessons learnt after yet another remarkable year. Our investment process is built on the key assertion that the direction of inflation and bond yields is the primary driver of relative asset class and factor returns. 2022 proved to be a perfect test case for the efficacy of our approach.

The year started with central banks realising the need for more decisive action on inflation. The shift in stance took on further

importance as Russia’s invasion of Ukraine pushed up energy and food prices. A healthy economy, tight labour markets and rising input costs caused a generational spike in the price of goods and services.

The Federal Reserve was emphatic in its response, and increased US policy rates by 3% in six short months. Financial assets suffered their worst start to the year since the 1970s. Bonds, the bedrock of multi-asset portfolios, were woefully mis-priced for a world of higher inflation, and as central banks rushed to raise policy rates, bond investors were left with large losses on their holdings.

We started the year with half our global and corporate bond allocations in short-duration bonds. The duration of a bond determines its sensitivity to rising yields. Our shorter duration stance helped mitigate some of the damage to portfolios. Our worst performing fixed income position was in UK gilts. The spike in UK yields during the Truss-era risked financial contagion and was a source of extreme volatility for many multi-asset portfolios. Our exposure to gilts was reduced going into 2022 as we envisaged a period of dollar strength. While gilt yields have since corrected, our positioning protected portfolios from the volatility that was unleashed during those fateful weeks. We have increased the duration of our bond holdings as the year has progressed, positioning portfolios for the eventual rally in bonds.

Global infrastructure allocations added in January have provided a ballast to portfolios in 2022. The sector has outperformed this year as investors have sought the safety of government-backed dividend streams. While rising yields have historically hindered infrastructure stocks, sharp increases have caused investors to seek the safety the asset class provides.

Within the equity market there has been a sharp and relentless sell-off in growth-tilted strategies. Having benefited from a decade of falling inflation and bond yields, growth managers failed to adapt to the rise in inflation. Their returns have retraced a decade’s worth of outperformance in six short months. Their undoing highlights the need for a factor aware process to fund selection. We sold out of growth tilted funds in March 2021. This year, we have favoured passive exposures in the US, UK, and European equities. We believe that a global recession in the next 12 months remains a high probability outcome and we have removed small-cap focused exposures to reduce risk.

Our approach throughout 2022 has been to reduce sources of unintended risk within portfolios. We closely monitor market-based signals such as breadth, factor performance and risk sentiment and stand ready to take advantage of the discounts on offer when asset prices start to recover. Expected returns for a wide range of assets have improved significantly as inflation and recession risks are simultaneously being priced into a variety of asset classes. It is important to have a disciplined approach when navigating periods of uncertainty as the final leg of a sell-off is often the most painful.

However, we take comfort that the first flushes of a recovery are often the most fruitful.


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