Preparing for the worst, hoping for the best
The first three months of 2022 have not heralded the calmer world many had hoped for. As the cost-of-living crisis bit here at home we have witnessed the appalling invasion of Ukraine and the energy crisis that it set off. The financial consequences of the conflict pale in comparison to its humanitarian impact and our thoughts are with the millions affected. There is no doubt that a situation like this, of soaring inflation and geo-political uncertainty, will leave a mark on even the most diversified portfolio.
Perhaps most significantly a shock to the world that brings inflation with it causes the bonds in portfolios to fall in value. Classically bonds rise during market shocks but an inflationary shock is different. The sell-off in government bonds seen over the past three months has been the largest since the early 1990s. However, as active managers we are not powerless in this situation and can do much to protect investors’ portfolios.
Commodity prices have risen sharply in recent weeks as the conflict has disrupted supply lines. Crude oil prices (below) rose by 39% during the quarter. The sharp rally in commodity prices has increased inflationary pressure just as central banks are struggling to control price expectations. Tight labour markets now risk kicking off a wage/price spiral which will be hard to contain and as investors we are doing much work to ensure portfolios can be rapidly adjusted to the benefit of our investors in this scenario.
There has been a significant shift in monetary policy in recent months. The chart below highlights the number Federal Reserve interest rate hikes expected by investors in 2022. Expectations have quickly moved from three hikes to eight. This shift is driven by the Fed’s hardened rhetoric and implies a 50 basis-point move at one of the remaining six Fed meetings.
Source – Bloomberg Fed Futures Model
The Bank of England (BoE) raised interest rates to 0.75% in March. The BoE’s move marked the first back-to-back increases in the bank rate since 2004. Quantitative easing, the buying of bonds by central banks, is simultaneously being stopped on both sides of the Atlantic.
The US yield curve (below), shows the difference between the yield on longer-dated government bonds and short-term bonds. It is a useful gauge of strain in the financial system and the risk that a recession is on the way. A zero reading has tended to lead a US recession by 12-18 months. This implies a US GDP contraction in 2023 and is a worrying omen for risk assets, for which we are preparing. It must be noted that every market environment offers opportunities for active investors such as ourselves, the key is careful preparing and planning.
Source – Bloomberg
Higher interest rates and rising geo-political risk have caused a rise in the US dollar. While sterling has fallen relative to the dollar, its decline pales in comparison to the yen. The Bank of Japan has refused to raise interest rates and has come under pressure as it tries to defend a 0.25% yield cap on 10-year Japanese government debt.
Source – Bloomberg
Equity markets have seen extreme volatility this year as rising yields have pressured growth stocks. The start of the conflict in Ukraine caused a selloff in banks, airlines, and consumer discretionary shares. European equities have suffered large declines as the region’s proximity to the conflict zone and its reliance on Russian gas has caused unease.
Preparing for increased volatility – Plan A:
Our approach in 2022 has been to cut sources of unintended risk. By removing emerging market exposure and reducing Asia and high yield allocations we have reduced geopolitical and currency risk within our portfolios. We have significantly increased our exposure to US dollar assets through our fixed income and equity allocations. Finally, we have increased our exposure to quality assets by increasing global infrastructure. Note that these steps were taken before the onset of Russian hostility. We have pre-emptively reduced unwanted sources of risk within portfolios enhancing our ability to weather increased volatility.
Our fixed income holdings have been under pressure due to central banks’ hawkish rhetoric. While the near-term outlook for bonds remains negative, fixed income allocations can provide genuine diversification, especially when inflation starts to decline. Half our global fixed income and corporate bond exposures are to shorter duration bonds. These holdings have helped limit the impact of rising rates on our portfolios.
In equities, we have increased our allocation to US equities as higher interest rates favour safe-haven currencies such as the US dollar. We have no emerging market exposure which has helped protect portfolios from the direct impact of Russian sanctions. Broad equity indices have declined over the quarter, with European equities and UK Mid-caps leading the decline. Chelverton UK Equity Growth, Jupiter Japan Income and Liontrust Special Situations have been the largest detractors. These funds are well run, with a long-term track record of active outperformance. We are in constant contact with their fund managers and feel the sell-off creates an attractive forward-looking opportunity for the funds.
The table below shows the performance the funds, held within core growth portfolios. Global infrastructure allocations have done well as their underlying exposures, non-cyclical sources of inflation linked revenues, have been unaffected. Our allocation to infrastructure increased significantly in 2022 and we believe the asset class provides a ballast in an uncertain macro environment.
Preparing for a policy error - Plan B:
Significantly tighter monetary policy and spiralling inflation present a worrying backdrop for equity markets. Equities have seen year to date weakness, but declines are a fraction of those seen during an economic recession. While we currently do not expect a recession, it is wise to have plan for such an outcome. The earliest signal of an economic slowdown will come from discretionary consumer spending. Spending on high ticket items such as autos and housing has often declined first when interest rates rise.
As 10-year treasury yields approach 3% and gilt yields 2%, forward looking risk adjusted returns for bonds become increasingly more attractive. This in and of itself argues for a shift in favour of bond allocations. Note that fixed income returns benefit from slowing inflation. We assume an economic slowdown would cause inflation to fall in this scenario. Should inflation expectations start to decline, we would look to buy longer dated bonds as they show greater price appreciation when yields decline.
The key consideration from an equity standpoint is our allocation to UK and European smaller companies. While we have retained much of our exposure to these two areas, an economic slowdown would pose a significant risk to these positions. We would remove our small cap exposures in favour of a large-cap quality focused approach in both regions.
Preparing for continued inflation and stagflation - Plan C:
This permanent shift in the inflation backdrop would represent the most challenging environment for portfolio construction. While we have seen some aspects of this backdrop in recent months, investors expect a limited longer-term impact.
The chart below shows 2-year, 5-year and 10-year inflation expectations in the US. While inflation expectations have clearly increased, longer dated (10 years) expectations are still anchored below 3%. If this environment changes, we would see a continued selloff in bonds as monetary policy would need to be tightened even further. We would reduce our longer dated bond allocations in favour of cash-like exposures. Gold and inflation-linked bonds which are part of our strategic asset allocation would see significantly higher allocations. We would need to consider an allocation to specific emerging markets. Portfolio volatility would remain elevated, and we would look to add strategies that do well when volatility rises.
Source - Bloomberg
The investment landscape has become more challenging in recent months. While we can pretend to know the future, we prefer to spend time understanding the appropriate shifts to portfolios to position them for the prevailing environment. Our approach reduces several behavioural risks that creep into investment decision-making. We spend as much time discussing portfolio implementation as we do reading the macro tea leaves. Our approach is rooted in enhancing portfolio outcomes, rather than predicting macro end points. We stand ready to make the changes we have discussed above when the weight of evidence favours this shift.