Market Update – June 2022
Chris Brown, CIO, 16th June 2022
Inflation remains front and centre for investors and markets. Hotter than expected CPI numbers saw the US federal reserve raise rates by 0.75% yesterday, with base rates now expected to peak at 3.75% next year in the US and at almost 3.5% here in the UK. As long as inflation keeps rising bond yields and equity valuations will remain under pressure. The MSCI World equity index is down -11% for the quarter in sterling terms as we write. UK government bonds are down -10%.
Given this backdrop, we think that there are three scenarios facing investors for the rest of the year:
- Inflation keeps surprising on the upside with equities and bonds falling (so the year carries on much as it has so far)
- Interest rates have risen enough to trigger the slowdown the central banks are looking for and inflation starts to fall
- Interest rates have already risen too much and a recession is on its way
We allocate, broadly, to equities, fixed income and alternatives. So far this year – and this quarter – our alternatives portfolio is up even as equities and fixed income have fallen. How likely is inflation to keep surprising on the upside? We think there are a couple of reasons to have some optimism here. The first is that interest rate rises work work with a lag and so we are only likely to see the real impact in the next few months. We have already a switch out of goods spending (i.e. things) into services (i.e. experiences including bars, restaurants and holidays) as the pandemic has ended. This means some of the pressure on goods inflation is starting to ease. Lease rates for cars have risen in line with interest rates. The 30 year mortgage rate (the most popular in the US) has more than doubled and is now over 6%. With a lag, this should cool house prices and investment and demand for cars. This should all ease pressure on the goods side of the economy and hence inflation.
The big risk, then, is on the services side and in particular wage inflation. Here, so far, the wages do not look to be chasing inflation higher (so triggering a wage/price spiral) as we show for the UK in Chart 1. If wages can stay under control then fixed income – with today’s higher yields on offer – would start to look attractive once again. Fixed income would also be a safe haven if (as may be the case) a recession is around the corner. The probabilities of this scenario happening is too large for us to ignore fixed income all together.
Scenario 2 – which is that the worst does not in fact happen – cannot be ignored either. There is an old joke that economists have predicted 9 out of the last 5 recessions. Equities remain the highest returning asset class and the best home for longer term investment. For this reason, we have kept much of our equity investments on. This kind of market volatility is never enjoyable to go through but is part of the cost you have to pay to make sure you capture all the longer-term return that is on offer.
Our strategy year to date
In part for the reasons we lay out above, the core of our investment portfolios remain equities and bonds. This means we cannot protect fully from the losses we have seen in both asset classes so far this year. We have, however, helped mitigate the impact in a few ways:
- We cut our equity exposure in April as recession risks
- We reallocated the proceeds to our alternatives Our alternatives assets are centred on real assets (such as renewable energy, infrastructure and specialist property) that are able to churn out inflation protected income in a wide variety of different economic scenarios. We are pleased that these assets have been able to continue to deliver this year. For those clients for whom inflation risks are front and centre, you should note that we now offer a Real Income portfolio which consists mostly of real assets such as these. Whilst it will probably lag as and when this inflationary cycle is over it has so far been well placed to deliver positive returns in the economic environment we are in today.
- One driver of inflation that we have not mentioned so far is commodities, and in particular energy/oil. Clearly, if the economy does remain strong and inflation is sticky then energy and mining stocks look attractive and (still) relatively Within our equity portfolios we have cut our (more interest rate sensitive) growth equity allocations and switched into cheaper, value style funds that have significant allocation to energy and miners. This should help us protect against any more commodity driven inflation shocks.
Finally, we are continuing to monitor the opportunities thrown up in fixed income markets. As an example, 10 year inflation protected US government bonds were yielding inflation minus 1.16% just one year ago. Today these bonds pay the US inflation rate plus 0.75%. This looks an appealing, low risk, inflation protected return. The silver lining from today’s losses in fixed income markets are that tomorrow’s returns now look a lot more attractive.
As ever, if you want to discuss our portfolios or positioning in more detail please do get in touch.