In spite of a generally favourable outlook for most of the global economy, with the diminishing impact of Covid and the lockdown measures designed to curb its spread, financial markets have been quite volatile since the start of 2022. Globally equity markets have dropped c.7% and global bonds are also down. Returns from UK equities have been broadly flat and UK government bonds have fallen 1.8% on concerns of more persistent inflation and rising interest rates.
What are the causes of the recent volatility?
There are several areas of worry for investors, but the main factor affecting market sentiment at present is the return of inflation. After many years of quantitative easing and low rates, inflation has started to be an increasing concern for central banks across major economies. This had been anticipated by economists, but the figures have been higher than expected (around 7% in the US and nearer 5% in the UK and continental Europe) and look to be more persistent than central banks had originally estimated. Additionally, inflation, which had been driven by rising energy costs and used car prices, has begun to creep into other areas including housing and food prices. Coupled with this, labour shortages have forced businesses to compete for staff, resulting in higher expected wage inflation in 2022. As a result, Central Banks have started to raise interest rates to combat these high inflation figures. Historically, a period of recalibration and a change in sector leadership is not unusual at times when interest rate expectations change direction, and we think that is what we are now experiencing. This tends to resolve itself over time, but we realise it can still be quite unsettling whilst it is happening.
Equity Markets
Within the equity regions, the picture has been mixed: The US and particularly the NASDAQ index have suffered quite significant drops, as have the funds exposed to them. UK Equities have generally been more resilient and Asian and Emerging markets have suffered least so far, both up nearly 1%, a reversal from 2021 when both China and Emerging Markets lost money and performed poorly compared to US and European Equities. Outside of the traditional equity and bond asset classes, we have also seen falls in the share prices of some property securities (REITs) and infrastructure funds this year, which has been disappointing in the short term, as these have been good diversifiers and continue to deliver strong, mainly inflation-linked, dividend returns.
Fixed Interest (Bonds)
As we have commented in the past, over the past decade or more, and despite some significant external shocks, investors have become accustomed to an environment of steady economic growth with low interest rates and inflation. This environment has supported returns across asset classes and has been particularly beneficial for bonds, resulting in elevated returns from an asset class that was perceived to be ‘low risk and low return’. However, while the current environment of high inflation and rising interest rates presents headwinds for most asset classes; arguably bonds face the most significant challenge and we have deliberately reduced exposure to these in recent years.
Coping with higher inflation
Equity markets have historically offered a better defence against rising prices, as companies are generally better able to pass on costs to their customers, but there can be quite a difference between industries and market sub-sectors. The prevailing trend in equity markets over recent years has favoured ‘growth’ companies which produce little income but offer prospects for future capital appreciation, and more recently ‘Lockdown’ Stocks such as Netflix and Amazon, have performed very well. However, in a higher inflation environment the promise (and future value) of ‘jam tomorrow’ becomes less attractive, so the share prices of growth companies tend to correct downwards which has been much in evidence so far this year. In anticipation of this over the past year we have been reducing exposure to Growth and Technology funds in favour of their more value focused peers. We have generally done this by taking profits and rotating out of Large Cap US and Global funds in favour of UK and European markets which have fewer Tech companies and more traditional value style businesses such as oil companies and banks. This has not offered a complete defence against falling markets but has significantly dampened the impact at a portfolio level.
Global Politics & Tensions
After a difficult 2021, Asia and Emerging Markets have held up a bit better this month as China, the key economy in the region, is moving in the opposite direction to other nations and increasing stimulus to its economy in the wake of an economic slowdown. However, we have been nervous of developments in China for some time, so have not significantly benefited from the short term gain, but were also more insulated from the falls last year. Prices in the region had arguably fallen to more attractive levels last year, and may yet become attractive, but we are mindful of the political risk one takes with significant exposure to a market where shareholder rights are not well respected and the Chinese Communist Party is increasingly assertive about its territorial claims to Taiwan which could yet escalate global risks.
Nearer to home, Russia is making similar sabre-rattling noises on the Ukrainian border and whilst we think the risk of a war that would draw in EU and US troops is still low, the imposition of sanctions and the inevitability of worse relations between the West and Russia could have a significant impact on markets and in particular energy prices.
Portfolio Positioning
At times of global uncertainty and risk aversion amongst investors, we think it is wise to keep portfolios well diversified, and to add to the traditionally defensive assets. These typically include the US dollar, Gold, and Japanese Equities. We would add to that, investments in UK Companies where valuations post-Brexit are significantly cheaper than their global peers, principally on the basis that it is still possible to purchase good quality businesses, producing good dividend income, with less downside risk. We also continue to like Infrastructure and Specialist Property which produce high levels of generally index linked income with a lower correlation to global equity markets. None of these are perhaps as exciting as high-growth tech stocks but preserving capital in volatile markets is often more important for long term investors.
In short, we have been making changes to portfolios over the past year or two in anticipation of the environment we now find ourselves in, which will have served clients well, but we can never be entirely immune to volatility. We remain long term investors and whilst we must be alive to new risks and threats, we continue to believe that; ignoring the noise, seeking value where we can find it and taking the view that over time markets are resilient and will recover from short term corrections if one is sufficiently patient, is the right approach. Over time that should leave us in a better position than if we over-react to short term shifts in sentiment.
TT 22.01.22
Investments can fall as well as rise and you may not get back the amount invested. This market commentary is not intended to be a recommendation to invest and should not be considered specific or individual recommendation. If you would like to discuss the implications for your own portfolio, please do contact us.