The new year has seen a complete about-face in markets, with the benign backdrop of 2021 giving way to very high volatility and falling share prices. To put the positives up front, our move to reduce portfolio risk in December proved well timed although we of course did not foresee recent events. However, this was clearly too small in light of the latest developments: the index
of global stock markets, the MSCI All Country World Index, is down c12% over 2022 to date, while the US technology heavy Nasdaq Composite has retreated by almost c19% (data as of US market open on 24 February 2022 in GBP).
The drivers of volatility have been two-fold. Central banks, probably under pressure from politicians, have performed an historic U-turn. From repeatedly asserting that the inflation spike would prove transitory – the simple mirror image of very low inflation through the periods of lock-down – they are now signalling a very aggressive pace of interest rate increases to address what is now perceived as a more enduring problem. Volatility from this source has been multiplied by events in eastern Europe, which have pushed energy prices sharply higher and triggered another down-leg in equity markets.
Prior to the invasion of Ukraine, the expectation of sharply higher interest rates had driven up government bond yields, with the US 10-year treasury yield increasing to 2.05% from 1.50% over the year to late February. This in turn prompted equity investors to rotate out of shares in companies with long duration cashflows and into lower-multiple cyclical stocks, where near term earnings are more geared to strong economic growth and less to changes in interest rates. Today’s events in eastern Europe have altered this dynamic – bond yields have reversed some of their increase to stand at 1.85% at the time of writing while, rather than rotating, equity markets are in broad retreat.
Our view prior to today was that central banks were running the risk of tightening policy into an already weakening global economy. It now seems likely that interest rate increases
and the re-establishment of central banks’ inflation-fighting credentials will be delayed or deferred as they assess the consequences of events in eastern Europe for the economic outlook.
Portfolio Positioning
Despite the unhelpful experience over the year to date, we believe our positioning is sensible both for the long term – and also should the impact of the Ukraine conflict meaningfully weaken the growth outlook. Our recommended global equity funds are populated with shares in high-quality companies with strong, secular growth characteristics and high returns on invested capital. For the most part these companies are continuing to deliver on, or beyond, expectations. They should be able to continue to compound earnings growth into the medium term and thereafter. Additionally, as their growth is not wholly dependent on the state of the world economy, they are less vulnerable to a downturn. In short, they remain precisely the businesses one should own not only for a world where globalisation, technology and network effects are increasingly important, but also one struggling to cope with disruption not just from post-covid readjustments but from the actions of Russia.
Turning to recommended bond allocations, these are balanced and include a degree of interest rate sensitivity. The aim of this was to offer protection in the face of unexpected setbacks which drive stock markets and interest rates lower. The interest rate sensitivity did not work in the early part of the year, though it is providing protection now.
Looking Ahead
Developments, such as those of the last 24-hours, can provide opportunities for long term investors. As you would expect, we are fully plugged in to our network of analysts, investment strategists and fund management groups to assess how the western governments will respond to Russian aggression and the implications for financial markets. We will be in contact to discuss our conclusions with regard to portfolio positioning.
