For the first time since the 1980s western economies have a real inflation problem. In looking for explanations many will blame central banks and governments for the overgenerous support packages put in place to address economies that had come to a standstill thanks to covid lockdowns. The central banks in turn may point to unwieldy supply chains which caused price surges in a small number of goods where production was interrupted. To this we can add more recent supply disruptions due to China’s zero-covid policy, and of course the Russia-Ukraine conflict’s impact on energy prices. Finally, changes in labour markets (the Great Resignation) and the transition to net-zero should also get a mention as factors contributing to the inflationary mess that the global economy now finds itself in.
For investors, the key fact is that, for the first time since the financial crisis, central banks are the enemy. That old cliché, ‘don’t fight the Fed’ has taken on a new, malign meaning. Serial interest rate increases to re-establish policy credibility and head off the highest inflation in forty years have driven bond prices sharply lower. This has impacted both the valuation basis for equities, and more recently, the corporate earnings outlook as it has become increasingly clear that the removal of so much policy support in a short time span is likely to lead to sharply slowing growth – or even recessions. As a result, as we approach the halfway point of the year, both equities and bonds have been hit hard, making this bear market in some ways more painful than the financial crisis. There has been nowhere to hide.
Our response to these developments has been to recommend cuts to equities and to shorten the interest rate sensitivity of our bond allocations. Despite these changes, portfolio values have been hit in the near-term. The ‘right’ places to be positioned in 2022 were those areas largely shunned in the prior two years including, of course, the energy producers. We have been underweight this sector as the outlook prior to the Russia- Ukraine conflict looked so unappealing. Notably, we see that even these areas are now coming under pressure as investors’ focus moves on from seeking out inflation hedges to finding areas resilient to an economic slowdown.
Looking ahead, we have three observations:
- Allocations to high-quality, growing companies in our recommended portfolios have been very unhelpful thus far this year as valuations here have been compressed by rising bond yields and profit taking. We believe that this trend is likely to reverse in due course as investors begin to focus on the excellent earnings resilience of such businesses in light of a rapidly deteriorating economic outlook.
- Having risen at an unprecedented pace, bond yields are likely to be close to their top; as the economic slowdown takes hold, investors should increasingly see value in bonds offering yields far higher than has been the case in recent years.
- One silver lining is that, although our programme of portfolio de-risking has been interrupted by the pace and severity of the correction, substantial allocations to defensive assets such as short-dated and inflation-linked bonds give us ammunition to put to work in now attractively valued risk assets in the coming weeks.
