Commentary on January 2022
Price volatility in investment markets, already concerned about inflation, rising interest rates and tensions in Eastern Europe, was accentuated by a technical position in the derivatives market. Developed economy equity markets ended the month 5% lower, though emerging markets fared better, losing only 1%. The exception to this sell-off was the main UK index, which gained 1% due to its high weighting in energy, mining and bank stocks, all beneficiaries of higher interest rates. Fixed interest bonds lost between 1 and 3% with UK gilts suffering the most.
The global economy expanded for a nineteenth straight month in January, according to the JPMorgan Global PMI™, although the pace of expansion slowed to an 18-month low. The slower rate of growth was expected, given the restraint shown by consumers in the face of the Omicron virus. However, employment data continued to surprise to the upside; the US saw a further 467,000 join the workforce in January, making over 900,000 jobs added over the Christmas and New Year period. In the UK the employment rate dropped to 4.1% and the number of job vacancies rose to a record high of 1,247,000.
Inflation remained the focus of attention with central bankers accepting that the word ‘transitory’ needed redefining. The United States topped the charts in the developed world with prices rising by 7%, the highest rate since 1982. Headline inflation in the UK hit 5.4% with the Euro area not far behind at 5.1%. One of the main drivers of this was the continued rise in energy prices, and that’s before the 17% rise in oil prices in January!
The New Year marked a tangible move towards central bank tightening. In early February the Bank of England raised rates by 0.25% to 0.5%; this was as expected but what did shock the markets was the revelation that 4 of the 9 voting members had voted for a 0.5% rise and that it was only the Governor’s casting vote that had prevented it. The US Federal Reserve laid the groundwork for raising rates at their March meeting, though opinion is much divided over whether this would amount to a 0.25% or 0.5% rise. Even the European Central Bank contributed with talk of higher rates this year, though a poor attempt was subsequently made to water down these remarks. Turkey’s President Erdogan produced a novel approach in dealing with the county’s 36% rise in prices-he sacked his Statistics Chief, who had the last laugh as subsequent data revealed annual inflation of 48%!
We expect that the dampening effects of the Omicron pandemic on growth will prove to be temporary and that as infection rates fall, pent-up consumer demand and receding supply bottlenecks will re-ignite global growth. We can be less certain of where that drives inflation but remain wary that markets are still pricing in a fairly quick return to ‘normal’.
Currently, bond yields and central bank monetary policy are driving equity markets, with the rotation from growth into value shares much in evidence. Year-to-date, UK bonds are showing losses of around 5%, yet the 10-year gilt yield is still only 1.4%, offering a real return (adjusted for inflation) of -4%! The yield on the German 10-year bond is offering a positive return (before inflation) for the first time since May 2019.
Central bank talk is getting tougher, with members in the US and UK, and some in Europe, now alluding to a series of rate hikes this year as well as a desire to bring forward quantitative tightening. The shape of the yield curve and forward breakeven rates still reflect market expectations for a short sharp shock with higher rates followed by a return to targeted inflation levels with slower growth, or possibly even recession, within a couple of years.
With high energy prices and rising taxes in the UK there has to be a risk of policy error but the perceived peak in interest rates is still only seen at somewhere below 3% (i.e. below the level of inflation), and little allowance has been made for a period of continued growth and the possibility of tight labour markets driving wages, and therefore prices, higher.
Interest rates are starting to rise, but cash and bond yields are a long way below inflation. Those with cash savings will see the real value of their money diminish unless they can find investments offering higher returns. In our view, a diversified portfolio, favouring equities over bonds, remains the best way of producing inflation-beating returns over the long term.
How are we currently positioned?
Our exposure to value-orientated funds helped the portfolios to outperform their benchmarks year-to-date.
Our portfolios have benefitted from a reduced weighting in fixed interest bonds more sensitive to rising interest rates. We are likely to remain underweight for the foreseeable future as yields still offer little reward for the potential risk of capital loss. In the portfolios that require bond exposure we favour those funds linked to inflation or rising interest rates and with limited exposure to rising yields.
Our portfolios diversify risk by investing in a wide range of assets using actively managed funds with sound investment processes. Some examples of these ‘alternative’ assets are funds invested in gold & silver, infrastructure, agriculture and absolute return strategies.