Multi-asset allocation views

Read this article to understand:

• Why inflation makes it harder to achieve positive real returns
• The role of fixed income
• How selectivity is critical in FX and equities

There was always a chance inflation would prove more persistent than expected. And so it has transpired. The UK is a good example: despite the price cap on energy, consensus forecasts still see CPI up around ten per cent year-on-year in early 2023.¹

The current inflationary regime has direct and indirect consequences for savings, financial markets and asset class returns. Multi-asset investors need to understand these to protect portfolios.

The consequences of inflation

One direct consequence of high and persistent inflation is that, at least over a short time period, it puts the expected return of many asset classes into negative territory in the absence of a forecast for strong capital gains.

In fixed income, yields rose significantly over the summer. Even prior to the mini-Budget in the UK, ten-year gilt yields had risen from under 2.25 per cent at the end of June 2022 to 3.5 per cent on September 23. But August’s CPI report showed inflation had risen by 9.9 per cent over the prior year.²

While there are a few UK-specific factors, rising yields are a global phenomenon. Global aggregate bonds have returned -12 per cent since the turn of the year, and yields have risen by nearly 2.3 percentage points.³ The fact bonds remain under pressure, even with this improvement in valuations, reflects similar concerns about a higher hurdle for real returns, and expectations of competition from cash rates. We are not confident fair value has yet been reached.

The list of indirect consequences is even longer, the two most important being the impact of price rises on the real economy and the policy response. In the current context, what economists call a nominal factor – price rises – is affecting real factors such as how much consumers are willing to spend and company profit margins.

This is highlighted by the cost-of-living crisis, where price rises outstrip people’s wage increases, resulting in concerns about whether their money will go far enough.  Surveys already point to sharp falls in consumer confidence, which we expect to affect discretionary household spending and ultimately corporate profitability.

The other consequence is driven by the monetary policy response to high inflation.

Central banks have delivered significantly higher interest rate increases than most observers, including themselves, forecast a year ago. The European Central Bank (ECB) and US Federal Reserve (Fed) are now expected to move in what are large increments by recent historical standards, hiking rates by 50 to 75 basis points (bps). For instance, the ECB raised rates by 75bps in September and is expected to do so again in October.⁴  The Bank of England (BoE), faced with sharp falls in sterling, is expected to move in bigger increments – perhaps exceeding 100bps – at some of its upcoming meetings.

Just as rising inflation creates a higher hurdle to turn nominal returns into real ones, rising cash rates create a higher hurdle to turn absolute returns into excess ones. The rise in bond yields, for example, is partly down to inflation and the real return hurdle. But it has also been about the opportunity-cost compared to cash. Interest rates are not only much higher than they have been, but are expected to rise further. As such, the idea of tying up cash in five- or ten-year government bonds is not yet attracting enough investors despite yield increases this year.

Nor are these effects purely to be seen in financial return calculus. The primary mechanism for higher rates to control inflation operates through the real economy. For instance, rising borrowing costs in the US, particularly for mortgages, have already had a cooling effect.⁵

All these factors impact sentiment. Market volatility measures, whether fixed income, FX or equity volatility, highlight the fragility of investor confidence, with the nexus of inflation, growth and interest rates causing concern for the future.

Figure 1: Volatility has increased

Source: Bloomberg, VIX, BofA. Data as of October 3, 2022

The role of fixed income

The question is, what can we do about it? First, investors must think very carefully about the role of fixed income, as we recently discussed (see Multi-asset allocation views: Is this the end of the 60/40 strategy?).⁶

The brief recap is we are no longer in a world where fixed income can do all three jobs of delivering consistent positive returns, hedging against short-term volatility in equities, and hedging against the risk of a deep recession. They can still do the last of those jobs, but we are looking to a more diversified set of assets to fulfil the first two.

As the role of fixed income has diminished, we have a slight underweight on the asset class overall. We have increased our focus on markets like Japan as US interest rates and Treasury yields have risen, but do not yet see enough value to justify holding fixed income at market weight.

In portfolios able to access a broader range of opportunities, alternatives can help protect against equity risk and we continue to use them. Absolute return funds, gold, and asset-backed securities all offer diversification from equities, without the risks currently facing core fixed income.

However, we are prepared to be opportunistic in bonds. We expect credit to remain volatile but have noted the steady increase in yields. It is important to recognise yield spikes tend to be fleeting – often before we have clearly exited a recession or interest rates are cut. We therefore bought back the underweights in high yield with which we entered the year.

Figure 2: High-yield valuations are improving (per cent)

Source: Bloomberg. Data as of October 3, 2022

Selectivity

It is also important to find opportunities through divergences in economic performance. One opportunity set closely tied to economics and interest rates is the currency market.

We see the US as a more resilient economy where investors underestimate the potential persistence of higher interest rates into 2023. By contrast, we believe investors were slow to appreciate the risks of quantitative restrictions on energy supply in Europe and uneven policymaking in the UK.

We expect the ECB and BoE to continue tightening, but they will be doing so against a weaker growth backdrop than the Fed. That difference between these economies has provided us with opportunities, and we remain long US dollars, initially versus the euro but latterly versus sterling.

As for stocks, rising inflation and interest rates make for a tougher environment to generate returns than when they are falling, especially if the growth outlook is uncertain. No one knows how much growth will have to be slowed or even reversed to control inflation, which creates headwinds to profitability.

Thinking about areas that offer better earnings resilience and risk/ reward in a regime of rising cost pressures throws up three possible defences. One is companies who produce goods in structurally short supply. That is why we invest in the European energy sector, not just as a play on high short-term prices. Decarbonisation, the political response to the energy crisis and the focus on security of supply makes Europe’s energy companies part of the policy solution rather than a problem. This provides those companies with a longer-term tailwind, even if some froth comes out of oil and gas prices in the near term. Importantly, the opportunity includes alternative and integrated energy providers.

Another part of the response is to find areas of demand more resistant to economic cycles. That is why we still favour the US. We see better scope for US companies to maintain margins in a stronger economy, whereas end markets are becoming more resistant to price increases in weaker economies.

Within that, we can find pockets of lesser economic sensitivity, where the key drivers of spending and revenues are not closely tied to sentiment and the business cycle. Staying with the US, we continue to like healthcare, which is cresting a wave of innovation and new product development, particularly on the back of technologies like mRNA vaccines.⁷ New products are coming at a time when the US economy is resilient enough to avoid major cutbacks in health spending.

On a relative basis, just as some currencies are better placed than others, some equity markets can be in a better position than others through their valuation, end-markets and industry makeup. For example, we like large-cap UK equities versus Europe.

Neither market is expensive, but the UK is particularly attractively valued, partly as a result of the persistent underperformance it saw in the COVID downturn and recovery. Its sector mix compared to Europe is less economically sensitive, and that resilience looks valuable. Some areas where we expect greater earnings resilience, like healthcare and energy, are well represented in the UK compared to Europe.

Figure 3: UK equities have outperformed Europe (local currency price return)

Source: Bloomberg. Data as of October 3, 2022

Because there is scope to find areas of greater resilience in equities, the challenging backdrop for earnings does not have to result in a wholesale retreat. Investors must be selective about where resilience can be found, and which companies will be able to retain pricing power and maintain their valuations. Even in an environment of high costs and rising rates, opportunities still exist.