Following the worst year in history for bonds and a challenging environment for many stocks and shares, investors saw some much-needed relief in the final quarter of last year. Globally, bonds and equities, on average, rallied from their October lows by 12% and 6%, respectively and investors were finally rewarded for holding a more diverse range of assets.
Cooling Inflation Expectations
Throughout 2022, the inflation outlook and central bank reaction function remained the key factors driving asset prices. Inflation reflects the rate cost of goods and services rise, and ever-higher inflation expectations weighed heavily on markets throughout the majority of 2022. However, these expectations began to cool in September of last year, and market participants reacted positively to the news that the top may well be in and, therefore, potential interest rate rises may be lessened from here.
Though this is undoubtedly good news, it is worth noting that lower-than-expected inflation does not mean that the prices of goods and services will collapse, but instead, they will rise less aggressively than they have more recently. This means that the previous price rises remain in the system, which will likely keep concerns elevated as companies, governments, and individuals get to grips with the new reality.
American Exceptionalism and Currency
In previous market summaries, we discussed the cushioning effects of a weaker pound on investors’ portfolios and how a strong dollar had offset the underperformance of American stocks last year. However, we have seen a reversal of this trend since September, as the dollar began to weaken against a basket of other currencies (figure 1). The weakening dollar has significantly affected US returns for UK investors like ourselves. For example, US stocks (MSCI North America) have risen by 10.57% since October, but a sterling investor would have seen a return of only 1.97% due to the weakening dollar. Though this has been negative for investments in the US, it has been positive for a broader range of equity markets. For example, an allocation to Europe, the UK, Emerging Markets and Chinese equities have contributed more positively to performance.
At inflection points like these, diversification within your portfolio is essential. A diverse range of geographical assets mitigates risk and helps maintain the opportunity set, as no market conditions persist indefinitely. The rear-view mirror remains one of the most significant risks for investors and any geography or investment style can go through prolonged periods of underperformance just as they can experience prolonged periods of outperformance.
Figure 1: US Dollar Index – 5 Years
One area that has seen perhaps the most significant change in fortunes is Chinese equities which seemed to reach their nadir at the end of October last year (down 33% at worst). Since then, and alongside the weakening dollar, the Chinese Government have indicated that the end of their zero-covid policy has arrived. Markets responded favourably to this news, and in a couple of months, we saw Chinese shares bounce 43%, erasing much of the losses of last year in spectacularly short order. In fact, Chinese equities (at the time of writing) have performed better than US equities and Global equities from the start of last year (figure 2).
Figure 2: Equity Performance – 31.12.2021 – 16.01.2022*
Last year we looked to keep our bond position relatively defensive. We held short-dated bonds (which have less interest rate sensitivity) and more cash. This helped protect the portfolios in a year where the most significant risk to client valuations was being overly exposed to bonds with high-interest rate sensitivity.
Figure 3: Fixed Income Performance – 31.12.2021 – 16.01.2022*
However, the situation is different now than at the start of 2022. Fixed income assets are trading at much higher yields and more attractive valuations than they have for several years. We have seen a rebound since October (figure 3), with index-linked gilts and gilts up circa 25% and 12%, respectively, but we would expect continued volatility and uncertainty from here. As such, we aim to be relatively defensively positioned whilst leveraging the expertise of managers’ with a more flexible remit. We have therefore broadened the regional exposure to more global bonds and increased our duration (interest-rate sensitivity) at the back end of last year and into this year. We will not, however, be looking to take on more exposure to high- yield (junk credit) at this stage as we expect default rates could pick up from here.
It is worth noting that last year’s market difficulties will present opportunities for investors despite the ongoing period of asset price readjustment we find ourselves in. Therefore, we feel it is more important than ever to remain calm, diversified and open to opportunities wherever they may present themselves, whether in bond markets, equity markets, commodities or infrastructure.
Final Thought: Inefficient frontiers and confusing outcomes
In various market updates, we have highlighted the difficulties lower-risk portfolios had last year as bonds sold off almost twice as much as equities (figure 4).
Figure 4: Discrete Calendar Year – Bond and Equity Performance
In this environment, we saw the benchmark, and many of our peers’ lower-risk products fall further than their respective high-risk portfolios into a falling market. Fortunately, our portfolios have maintained the credentials you would expect – i.e. the low-risk portfolios have lost the least, and the higher-risk portfolios have lost the most (figure 5). Interestingly, and since the dollar has rallied, some of the peer group has exhibited similarly confusing outcomes in the market bounce. We have seen their low-risk portfolios participate more into a rising market than their high-risk portfolios. Mainly due to their concentrated dollar/ US positioning. On the other hand, our portfolios have performed as expected whereby our higher-risk portfolios have rallied further than our lower-risk portfolios in a rising market.
Figure 5: 1 Year Scatter – MPS Core Portfolios*
*Information displayed is short term in nature to demonstrate performance over a specific time period. Please contact IBOSS for long term data, including since launch and/or 5 years.
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