Equity and bond markets are currently looking difficult to invest in.
- Tuesday, May 24, 2022
2022 has been unprecedented in terms of the challenges facing the world economy. The post covid boost in asset values due to massive government stimulus funding and interest rate cuts has been replaced by tightening, high inflation and interest rate rises. We have over the past six months seen a historic re-pricing of asset values in response to the tightening of monetary policy due to raising inflation.
Covid is still hurting economies where the vaccine roll out has not been extensive enough to avoid further lockdowns. Added to this, is the on-going conflict in Ukraine which is likely to continue for many months to come. The only real game changer looks to be the ending of European purchases of Russian gas as this is what is funding Putin’s war.
A negotiated settlement over the land that includes Mariupol and the Donbas region is very unlikely given the defence the Ukrainian army has put up to retain the city and surrounding areas. This war could rumble on for many more months until cutting off Russian funding becomes a reality. The implications to Germany and wider Europe would be recession and higher unemployment and that is why it is being resisted. This war has been a difficult lesson for many European governments over their energy supply.
We should expect the development of far greater investment in new energy sources but this cannot happen overnight. The move from coal, gas and oil will happen but investment in theses energy sources will continue at least until the alternatives are more advanced in supply volumes and reliability.
Looking ahead, equities often continue to rise when economic growth is slowing but positive. The big question now is whether there will be a recession. When markets fall and no recession occurs, the recovery tends to take a matter of months. However, market falls associated with recessions often take a much longer to recover from. While the chance of recession this year is higher than it was a few months ago, it’s still not likely in many fund managers opinion. For this reason, we are staying invested in sectors that show some attraction even in a difficult environment.
Edition 37 of our portfolios is different than past editions. We asked investors their view over the merging of our Alpha and Beta portfolios into a combined hybrid range of both active and passive funds. This proposal was made on the back of our desire for more consistent investment returns and a reduction in fund management costs.
Edition 36, launched in December 2021 was overall a cautious edition as we were expecting inflation, interest rate rises and some challenges over growth. This has proved to be the case. All equity assets have been challenged while the bond market at every duration has fallen in value as interest rates and yields increased.
We are generally reluctant to make big sell downs of assets at a low valuation but there are assets and sectors that we feel are unlikely to recover for a while and that capital is better allocated elsewhere.
Markets we are cautious about are:
US Tech and growth stock.
This sector has had a very good run and much of the returns since the March 2020 Covid correction were a result of our over weight position in US growth and tech stock. With the Federal Reserve having announced a 0.5% rate rise and indicated more significant rate rises to come through the summer it will mean debt will be more expensive and this will impact growth stock, tech stock and green energy stock. We could see US interest rates hit 2.25% -2.5% by the end of the year. The alternative to US growth stock is US equity income value stock which invest in traditional cash flow focused businesses benefiting from post Covid activity. The JP Morgan US Equity Income Fund is our recommendation.
Long Dated Bonds and Government Bonds.
As interest rates rise, bond yields will follow and, in many cases lead. The US 10 -year treasury yields have risen 83% from 1.65% to 3.03% in the past 12 months. Analysts still feel that 10-year treasury yields have further to go from the current positions and that bond markets will struggle until inflation starts to decline. Bond holdings have been seen as the safe haven asset but the cocktail of inflation and rising interest rates are forcing down prices. The longer the duration of a fixed interest security the more exposed to real return loss there will be. Government gilts and index linked gilts offer longer durations and are loss making assets at the moment. While all blended portfolios would include a bond holding, ours are currently in hedged, floating rate, short dated, inflation linked or high yielding in nature to minimise losses. The Royal London Diversified Assets Fund is a hedged bond fund and one of our recommendations. Our play on interest rate rises is the inclusion of the M&G Floating Rate High Yield Fund which invests in fixed interest where yields follow the base rate. We are also holding higher weightings in cash for the duration of this 37th Edition.
Gold is selected when markets are under pressure and inflation a threat. We are in these times now and have been holding gold for these reasons. However, interest rate rises are pushing up bond yields so making bonds more attractive. The strengthening of the US$ is making the currency an alternative to gold as well. If inflation does peak in Q3 then gold is likely to become less attractive.
Europe and in particular Germany, has got itself into an energy supply crisis of its own making. Decades of trading with Russia has resulted in over dependency. The Russian annexation of Crimea in 2014 should have been a warning and started the search for new and diversified sources of energy. European governments will need to invest in alternative reliable sources of energy. The continent is feeling the energy cost spike which is unlikely to be resolved soon. The longer the Ukraine conflict goes on for will have a growing negative impact upon Europe. As no one cannot foresee any early settlement to Russian actions we feel that a greatly underweighted position in Europe is justified.
Markets that we remain neutral on are:
China. China has been a great growth story and has been held in our portfolio for many editions. We are conscious that China has a number of challenges over its zero Covid policy, the mass regional and city lockdowns and the low level of the elderly population vaccinated. This has resulted in low production and stalling exports. The harsh lock downs are expected to start ending and Beijing is determined to ease monetary and fiscal policy to encourage growth. While we have seen significant falls in Chinese equity values the government stimulus and low interest rates are likely to come through with improving returns for China and the Asia region. We have retained our holdings in FSSS Greater China Growth and added Schroder Asian Income.
The factors that influence returns in Japan is the relative strength of the Yen. The Japanese government seek to weaken the ¥ in order to boost export sales. The ¥ to £ has weakened recently and that investment returns have been undermined by the currency exchange. In future to counter this problem we will hold a hedged version of a Japanese equity index. This potential of improvement in China will aid Japanese companies. We are holding a modest holding in Fidelity Index Japan Hedged Fund.
We believe that clean energy funds are a force for global good and that economics will drive change quicker than politicians. The clean energy sector is set to grow significantly over the years ahead as the world moves away from fossil fuels. We are cautious on this sector, due to the levels of debt in clean energy stocks that will be hit by higher borrowing costs. For this reason, we have closed our position in Baillie Gifford Positive Change Fund but retained our holdings in Guinness Sustainable Energy Fund.
Markets we are more attracted to are:
The UK equity markets and particularly the FTSE 100 has been undervalued and hold companies in the banking, energy, commodity mining, supermarkets, pharmaceuticals and defence sectors. These are seen as defensive sectors and collectively earn US$ income abroad which is beneficial while the US$ is strong. We have maintained our positions in the UK in funds like the HSBC FTSE 100 index and Vanguard FTSE All Share index.
US Equity Income.
We are actively avoiding exposure to US growth and tech stocks while we go through a period of interest rate rises, we are happy to invest into the value side of the US stock markets and into American companies with strong cash flows and needed services. This again is a defensive play. The alternative to US growth stock is US Equity Income value stock which invest in traditional cash flow focused businesses benefiting from post Covid activity. We are holding the JP Morgan US Equity Income Fund and T. Rowe Price US Large Cap Growth and HSBC American Index.
We have always sought to diversify our portfolios with the inclusion of alternative assets to provide diversity to our portfolios. That diversity is as important as ever at the moment. The specialist sectors that have done well over recent months when other equity has declined have been property funds, listed infrastructure, natural resources and commodities, energy and listed insurance markets. We have held all of these assets and each has provided at different times positive returns to the portfolios. The recent Fed rate hike falls dragged some particularly property down but overall, these sectors have enjoyed growth over the past three and six months.
We are invested in the iShares Global Property Securities, Franklyn Templeton Clearbridge Listed Infrastructure, JP Morgan Natural Resources, Polar Capital Global Insurance.
The historic re-pricing of all main asset classes due to the tightening of monetary policy in response to raising inflation is likely to continue and investors can expect difficult times at least until inflation is declining and investors have something to comfort them.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.