Insights
Managing Portfolios in an Inflationary World
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PATH
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April 01, 2022
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April 01, 2022
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Managing Portfolios in an Inflationary World |
Equities rallied in the final two weeks of March, with developed market equities recouping part of their YTD losses. The S&P 500 (USD) ended the month up 3.7%1, the MSCI Europe (EUR) returning 1.0%1 and the MSCI Japan (JPY) up 5.0%1, whilst the MSCI Emerging Markets (USD) fell -2.2%1. Oil prices continued to crank higher due to the Russia-Ukraine war, with the benchmark WTI at one point reaching $123bbl2, before pulling back to $100bbl1 by month end, as China’s lockdowns dampened demand. The VIX came down significantly from 36.53, finishing March at 20.61. Bonds sold off, with the US 10-year Treasury yield jumping to 2.3%1 by March end.
Is the rally a short-term reversal?
This year’s sell-off appears to have been driven by sentiment, not an earnings recession. Commodity-exporting countries are showing the most value, though most equities no longer appear expensive,4 with the US the exception. Earnings are still expected to grow around 9% over the next 12 months5.
However, the risk is markets take another leg lower and 2022 growth expectations get downgraded. Moreover, the major macro themes reinforce two outcomes: higher inflation and weaker growth. Both the war in Ukraine and China’s renewed lockdowns put upside pressure on inflation and downward pressure on growth, as well as exacerbating supply chain disruptions, particularly for commodities from Russia.
The Fed hikes and signals aggressive tightening to come
Central bank policy is also being watched closely. As US inflation accelerated to a 40-year high of 7.9%6 in February, March’s FOMC meeting brought the first rate hike since 2018. Chairman Powell signaled aggressive tightening, citing a potential 50bps hike in May. He indicated that the economy should be able to withstand the pace, as should the labour market which is “tight to an unhealthy level7” - another acknowledgement the Fed may be behind the curve. The Fed Funds futures are reflecting market and Fed alignment, with 7-8 rate hikes in 2022 and 4 in 2023.
Investment Implications
We maintain low equity exposure, reflecting our defensive positioning. In addition to the broad commodities for portfolios which permit, we have included further inflation hedges and initiated downside growth hedges, such as gold and have lengthened duration.
US 10-Year breakeven
We have added an overweight to US 10-Year breakevens, to hedge against protracted inflation in 2022 and de-anchoring of US inflation expectations. Despite already lofty valuations, the recent commodity price spike further contributes to high core inflation. We have added to US rather than European inflation, as we believe US inflation is more structural than in Europe, where only some of the main components have been impacted (food and energy). In contrast, the US is experiencing more broad-based inflation, with wage increases also reenforcing the dynamics.
Energy
We added to our energy overweight, which should continue to benefit from higher equilibrium energy prices.
Gold
For portfolios which permit, we initiated an overweight to gold, as a diversifier of geopolitical risks, particularly in the face of global growth fears. Sanctions on Russia have reinforced gold’s role as the currency of last resort. Compared to other commodities, gold is still attractively valued.
Duration
We moved from underweight to neutral duration. Long-end yields will likely remain capped, as the growth outlook deteriorates, due to the commodity supply shock. Central banks, led by the Fed, should continue to hike into slowing growth to keep inflation in check, leaving front-end rates to trade with an upside bias.
Eurozone equities, financials and UK equities
We reduced exposure to eurozone equities, given stronger links to Russia, relative to the US and rising risk of recession in Europe. We reflected this through reducing European banks, expressed in some portfolios through a removal of global financials. We added an overweight to UK equities, to gain exposure to UK banks, as well as materials, energy and consumer staples. This is not only a defensive play, but also an inflation hedge due to high commodities exposure, relative to Europe.
Chinese internet
We removed our position in Chinese internet stocks, due to heightened global volatility from the Russia-Ukraine conflict, the potential increase in US-China tensions and renewed lockdowns in China. Although attractive in the longer-term, near term they are likely to remain under pressure from negative sentiment.
Tactical positioning
We have provided our tactical views below:
RISK CONSIDERATIONS
There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio.
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Managing Director
Global Balanced Risk Control Team
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Managing Director
Global Balanced Risk Control Team
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