Within two months market expectations have gone from one to four interest rate rises and have repriced accordingly.
- Tuesday, January 25, 2022
The investment outlook has changed over the past few weeks which has led to major global markets falling in value. The US tech company index the NASDAQ has lost -12% over the past month. These falls have not been the result of Omicron or supply chain inefficiency. The former is proving to be highly transmissible but not deadly, as high vaccination rates have provided protection, while the latter is improving with reducing supply times and falling container shipping costs.
The factors that prompted the market fall off over recent weeks is the changed position of the US Federal Reserve. Back in October 2021, US markets were encouraged by the better-than-expected Q3 corporate earnings results and the pricing in of one interest rate rise in 2022. Any rate rises were expected only after the Fed had concluded its quantitative easing tapering from US$120bn per month ending in the summer of 2022.
In October, US inflation was high at 6.2% as a result of increased costs in the second-hand car market, air fares, reopening demand and inefficient supply chains. The Feds position was not to tighten too early even with inflation hitting 6.2%. Markets were priced for a one rate rise as the Feds conditions for rising rates any more were unlikely to be met particularly the US unemployment target.
In October, the US unemployment rate stood at 4.6% but now stands at 3.9% due to a sustained recovery in the jobs market. In 2021 there were 6.4 million new jobs created averaging 537,000 per month. The labour market recovery has been faster than expected which is good news for growth and earnings. A 3.9% unemployment rate is the lowest since the pre-pandemic low of 3.5%.
There have been some noticeable changes to the US workforce and it is this that has influenced the Fed’s thinking. Post lock downs, older and wealthier workers are not returning to employment as was expected and are actually leaving the job market. As a result, vacancies remain high and this is driving wage growth. The Fed feels that the US job market is very near full employment for those seeking work. The Feds response is to accelerate the tapering of its QE programme to finish by April so that it can start to increase interest rates sooner. Markets are expecting four rate rises this year, the first in March or April and then quarterly until the end of the year. Interest rates are currently 0.25% and are expected to end the year at 1% – 1.25%, rising to 1.5% in 2023.
Within two months the market expectations have gone from one to four rate rises and have repriced accordingly.
US inflation is thought to now have peaked this month at 7% driven up by a broader range of cost increases which now includes energy, housing and food bills that are more essential household spending. US inflation is expected to fall from here to around 3% by the end of 2022.
The pressure of inflation and the expected interest rate rises have resulted in US 10-year treasury bond yields increasing to 1.85%. There is some expectation that yields will rise further to 2-2.25% but not in the near term as yields have already priced in the interest rate and inflation expectations.
Central Bankers will not wish to rise interest rates more than they need to as the cost of servicing the excessive national debts will rise. A 1% increase in UK interest rates would cost the UK Treasury a further £20bn in interest payments that will have to be funded by taxation or even more borrowing.
The prospects of higher interest rates have particularly hurt those companies and sectors that are high growth, low earnings, highly leveraged businesses typified by the tech and green energy sectors which have been borrowing to satisfy demand. The US NASDAQ fell -12% in the past month as compared to the broader S&P 500 which was down -6.8%. The most expensively priced growth stocks have been the hardest hit.
We have traditionally held an overweight position in US growth stock for many years that has proven to be very successful but our overweight position has turned against us over the past few weeks.
As the world progressively moves to the new norm of living with Covid then traditional industries and sectors will return to favour. The companies that excelled during lockdown were tech companies but as spending moves to travel, social leisure and normal consumption then the stock values of traditional businesses will rally at some expense to tech stocks. We have followed this trend by investing into value and revenue driven sectors by holding funds like the HSBC FTSE 100 Index Fund, Allianz Continental European Fund and the JP Morgan US Equity Income in the latest Edition 36.
We still have a strong long-term belief in the US economy and see the tech and green energy sectors leading the next industrial revolution. While these funds are having a tough time right now, we still wish to hold on to them. Edition 36 has retained its holdings in Baillie Gifford American, Baillie Gifford International, Baillie Gifford Positive Change, Guinness Sustainable Energy, Polar Capital Global Technology.
The US stock market is seen as being expensively priced and there are cheaper markets to access for growth. The UK, Europe, Asia and China are priced below their US counterparts and therefore investing globally makes sense from both a cost and diversification point of view.
Since the Brexit Referendum in June 2016, the FTSE 100 index has underperformed many other developed markets. However, since the December 2019 General Election it has improved and in particular since the success of the UK vaccination roll out has become one of the better performing stock markets. Cheaper priced markets have faired better in recent months which is why for example, the FTSE 100 in up + 1.5% and the S&P 500 down -6.8% over the past four weeks. We have held an underweight position on UK stock allocation since 2016 and this underweight has gone against us recently.
UK inflation hit 5.4% in December, but is not expected to peak until April when energy cost increases will impact household bills and inflation expected to exceed 6%. The Bank of England (BoE) is thought likely to make three more rate rises to end 2022 on a 1% base rate. Analysts do not expect UK interest rates to head above the 1.25% as this would impact the economy. UK unemployment has fallen to 4.1%. Similar to the USA, UK unemployment is falling back to close to pre pandemic levels but 1.2 million unfilled job vacancies still exist which is pushing up wage inflation.
The Chinese main stock market, the Shanghai Composite Index treaded water throughout 2021 after having enjoyed solid growth in both 2019 and 2020. This lacklustre performance was in part to the Chinese property market being over leveraged and overpriced, the Chinese authorities monetary tightening policies along with regulatory interventions and energy blackouts.
The Chinese authorities had been tightening when other governments and central banks were loosening their monetary policies. We are now seeing these policies reversed as China cut it mortgage rates last week which in turn lifted Chinese stock markets. Overall, Chinese stock markets fared poorly in 2021 but now look set to respond to renewed government stimulus.
The infamous Zero Covid policy did not impact upon China’s growth in 2021 as production and exports were strong. The Zero Covid policy is likely to remain in place this year or at least until the Communist Party Conference in the Autumn where President Xi Jinping is seeking a third term in office. The Chinese developed vaccine Sinovax has been far less effective than the West equivalents as it does not build up sufficiently strong antibodies to offer lasting protection for the Chinese population. We do expect China to try to develop a more effective vaccine or even an antiviral pill.
Fixed interest bonds make up a meaningful part of any diversified portfolio and in order to protect the bond allocation from the impact of rising US treasury yields and the pressure this will have on bond prices we have taken a range of actions over the past nine months.
We have firstly reduced our exposure to much long-dated credit by holding a majority of short duration bonds that while offering lower overall returns are less exposed to inflation and interest rate rises. We have added to our inflation linked holdings so that returns are in line with the increases in inflation. We also continue to hold global high yielding bonds where the rate of yield has some inflation protection within it.
We have newly introduced two bond funds that use hedging techniques to create a smoother return profile. These are the Artemis Target Return Bond and the Royal London Diversified Asset Backed Securities Fund. We have also introduced a floating rate bond fund that takes advantage of rising interest rates. This being the M&G Global Floating Rate High Yield Fund.
The fixed interest securities will be under pressure from inflation and rising yields but the diversity of holdings will offer some protection. We have prioritised these above returns over this next six-month period as markets move from stimulus and cheap money to policy tightening and inflation peaks.
Bond yields will influence stock sector returns this year. If yields remain relatively static then the growth sector will recover. If yields increase then the traditional cash flow revenue sectors including big tech will benefit more. Corporate earnings will be key to equity values and the opening up of the global economy while the pent-up demand within consumers will help. Analysts have suggested that the spending power of consumers could be sufficient to counter the impact of interest rate rises of up to 1% this year.
The Edition 36 Portfolios have a range of diversified assets that spread the opportunity for growth and stability of returns. We have increased our allocation to the iShares Global Property Securities Fund as commercial property rents offer some inflation protection. Commercial property has recovered well and offers a different investment dynamic to both equity and bonds. The same can be said for infrastructure funds that invest into major development projects. We have for many years held the First Sentier Global Listed Infrastructure Fund.
We have retained our recent holdings in the JPM Natural Resources fund. This gives the portfolio access to the demand for commodities and in particular copper, oil and gas. Commodities are a hedge on inflation and have enjoyed attractive returns in the past year. We have introduced The BlackRock Gold and General Fund to provide a defensive allocation against market uncertainty and inflation. Gold can be volatile so we will only hold it when needed.
With interest rates expected to rise then the banking sector will start to see improvements in the profits made from its loan book. For this reason, we have supported the Jupiter Financial Opportunities Trust.
The new and growing concern for markets is the standoff phoney war between Russia and the West over their intentions with Ukraine. The threat of a destabilising conflict is real but hopefully unlikely. Only the Russian stock market has reacted to these implications by falling in value. Moscow’s MOEX index has fallen from a high of 4255 in early November to 3439 today. A drop of 19%.
The West is divided and Germany is compromised as it heavily relies upon Russian gas imports. President Biden even if by blunder, hinted that a minor invasion could be tolerated. What would the West’s response be to an incursion? Would sanctions be placed upon the export of gas and oil as the resultant global energy prices would be crippling. Russia’s resources and robust financial position could also withstand such sanctions. President Putin may be enjoying his political game with the NATO nations and let us hope that’s what it remains. As of yesterday the stock markets of the West caught up with the escalation in tension and saw 3% to 4% written off their values.
The cross current of peak inflation and expected interest rate rises is an investment landscape we have not seen for many years. The bull market for bonds is now over with yields rising and prices falling particularly for government bonds. The cautious and diversified nature of the portfolio is appropriate for the times. We have suffered from an overweight in US stock at a time when we were underweighted in UK stock but this could reverse over the months and years ahead. We are exposed to risk in order to achieve capital returns but that risk is off set to a degree by the portfolio diversification.
May I thank everyone who has responded to our recent request to rebalance your portfolio to the new Edition 36. If you are yet to do so, may I encourage you to. Thanks.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.