Markets have shifted dramatically over the past year, with investors still adjusting.
Inflation is now at a four-decade high, with the Bank of England in August anticipating a peek of “just over 13% in 2022 Q4… before falling to the 2% target two years ahead”. That 2% is looking a little optimistic.
Low-Risk Bonds Look Risky
With all these threats, investors will naturally be looking for safe havens. But what constitutes a haven in this environment? Cash savings won’t so much be eaten up as devoured by inflation.
The immediate prospects for bonds don’t look great. While the previous period past two decades had left bonds bloated and yields unattractive, the balloon has been punctures. As a result, active managers have been finding attractive fixed income opportunities. Nevertheless, bond valuations will be hit further if inflation rates have further to go, which seems likely. As a result, bond allocations have been strongly negative, while still positive for passives ETFs (£1.4bn redemptions in July, but with £769m inflows for bond ETFs).
This seems counterintuitive: after all, active managers can select those bonds that look best placed to weather this environment, while shunning the basket cases. Passive funds, on the other hand, tend to be overexposed to the most indebted entities. The likely answer is that asset allocators are topping up the fixed income elements of their portfolios and are choosing to do it with vehicles that are both liquid and transparent, so it’s clear the effect that this will have on the risk profile of your portfolio. Plus, with an ETF you can get in and out quickly.
Multi-asset also faces challenges, irrespective of risk profile, as my colleague Detlef Glow pointed out, as “while the managers of mixed-assets funds could rely on decreasing interest rates, which lead to higher prices for the bonds within their portfolios…[it] seems to be different this time…the spreads of corporate bonds have started to widen as the economic situation puts the earnings expectations for a number of companies and some sectors into jeopardy. As a result, corporate and government bonds face losses, which means that the returns from the bond portion of portfolios won’t help to offset the negative returns from the equity portion.”
The Value Comeback
One potential area of interest is equity income. Lagging and unloved for so long, it seems well positioned for a comeback. The UK iteration has lost 3.1% over the 12 months to the end of August, compared to a loss of 10.1% for UK All Companies, and performed well compared to other national markets.
This is a result, in part, of the rotation from growth to value. Up until the market rebounded in late 2020, value had underperformed growth for most of this century. What’s perhaps a little odd is that this hasn’t translated into a revival in positive interest in UK equity income funds, where we’re still seeing significant redemptions. This could be because most holders of UK equity funds are domestic investors, structurally overweight the sector, and this is a secular recalibration.
Much of the case for equity income rests on how present rather than future cash flows are valued by markets. From the start of the twenty-first century until COVID drove a wrecking ball through global supply chains, we had lived in a world of accommodative monetary policy, low inflation, and low rates. That bolstered growth stocks such as S&P leviathans Meta and Netflix, increasing the value of future cash flows relative to current ones. Inflation throws this into reverse, with current cash flows (especially dividends) being more valuable. In essence, whether a bird in the hand is worth two in the bush depends on what the base rate is.
That’s good for the UK market, as it’s historically been more dependent on dividends for its total return. It also played out well in the first half of 2022, as UK equities were not hit quite so hard by the global equity market falls. However, the UK market has lagged the US and global value indices over the summer (chart) and, given the OECD’s forecast that the UK will be the weakest G20 economy bar Russia, may continue to do so. This could favour US or global value funds, and UK value has indeed rescinded its lead during the first half of the year in the third quarter, with Global Equity Income outperforming its UK peer over 12 months, returning 2.2%, also attracting £1bn of UK investor cash.
Chart 1: UK, US and Global Growth v Value, Q1-Q3 2022
Source: Refinitiv Lipper
In a low-to-negative growth environment, a shift to bonds would be prudent—but only if rates aren’t trending upwards—cutting the legs from under bond valuations. When this stabilises, investors have some certainty with fixed income. Until that time, the fixed income portions of portfolios will continue to be under threat.
On the other hand, equities are growth assets, so vulnerable to any recession. However, they beat inflation over the long term, particularly those stocks where dividends play a large part in their return.
Over the coming months, the playoff between recession and inflation—something both dynamic and not either/or—will determine the optimal mix for investors. If the Bank of England is correct in its forecast of a return to inflation of 2% within two years, then the game once again changes. But that’s a pretty big if.
This article was originally published in Personal Finance Professional.
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The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.
