Commentary on March 2022
From an economic point of view, the past few weeks have been dominated by concerns over the ongoing rise of inflation and the consequent rise in interest rates. Despite this, or possibly because equities were seen as the best way of keeping pace with inflation, stock markets rallied from their mid-month low to close the month in positive territory. In sterling terms, shares in the United States and Asia led the way with gains of 4-5%; indices in the United Kingdom, Europe and Japan reflected a rise of between 1 and 2%. Since the Russian invasion of Ukraine, developed markets are now some 4-6% higher, although it’s worth noting that UK government bonds are sharply lower with falls of 5%, and over 8% in the index-linked variety. For bonds this is a big deal!
Economic releases, reporting on the world before Russia-related sanctions, confirmed further growth but with a switch in emphasis from a manufacturing sector still suffering from a shortage of labour and supplies, to the service sector boosted by an easing in lockdown restrictions. The unemployment rates in the US and UK fell further and unfilled positions reached record highs. Worthy of note was a widespread fall in confidence, which could be attributed to a combination of the ongoing atrocities in Ukraine and the rise in costs of living.
The cost of living continued to rise at an alarming rate; inflation in the United States, Europe and United Kingdom was higher than expected at 8.5%, 7.5%, and 7% respectively. Optimists pointed out that some one-off factors like used car prices were rolling over and that much of the current rise was down to ‘base effects’ (historically lower prices). However, in the UK, the average 54% rise in energy bills that came into effect on 1 April, is forecast to add 1.6 percentage points to next month’s number, bringing headline inflation close to 9%.
In the United States, Hell had no fury like the wrath of a central bank that had mis-judged inflation. The 0.25% rise in rates was small and as expected, but the warning to expect a further six increases during the year took traders by surprise. Federal Reserve Chair Powell warned that rates could rise by 0.5% on more than one occasion and that the Fed would “move to more restrictive levels if that is what is required to restore price stability”. In contrast, the Bank of England raised rates by a more credible 0.5% but suggested that further tightening would continue at a slower pace, due to uncertainties surrounding the economic outlook. The European Central Bank maintained rates at current levels and confirmed plans to end its bond purchases in the third quarter of 2022.
A major talking point over the past month has been the US yield curve inversion (bear with me!).This was caused by the yield on shorter-dated bonds (maturing in 2 or 5 years) rising by more than the yield on longer-dated bonds (maturing in 10 years) to the point that a 10-year bond was briefly yielding less than one maturing 5 years earlier. This isn’t normal and is significant because it has a consistent record in signalling a future recession.
The argument was that shorter yields were anticipating the series of interest rate rises expected from the US Federal Reserve whilst longer yields reflected the expectation of a policy error by the Fed’, tightening too far and resulting in a recession in 2023-24. The counter-argument being offered is that after years of being manipulated by central bank buying, bond market yields were starting at the wrong level and, due to the vast amounts held and traded by central banks, could no longer be trusted as a market signal.
Much of the world remains in rude health with strong consumer demand and corporate earnings being declared above forecast. And even after the anticipated rises, interest rates will still be close to historically low levels. On the flip-side, the rising cost of living will not only challenge central bankers but will start to weigh on household budgets. Various degrees of lockdown in China have seen output and demand in the world’s second largest economy weaken, and we have arguably the highest geopolitical tensions for decades.
In the near term, we feel that investors may be a touch complacent and that further shocks to market confidence will emerge from time to time. But the returns on cash and bonds remain well below the current levels of inflation, diminishing the real value of savings. We remain of the view that 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?
The recent rally meant that prices moved away from the entry points that we had identified, but we don’t feel that this is a market to chase. We believe that opportunities will present themselves again and if the rally continues, it might be worth taking some profits on existing holdings.
We are likely to remain underweight fixed interest 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.