These factors, combined with a savage rotation within investment styles have led to one of the toughest market backdrops for a long time.
Q1 2022 witnessed significant divergence in equity market performance: UK equities were up slightly by 0.5%; UK smaller companies were down 11.4%; Europe was down 7.4%. Fixed income provided little protection with UK government bonds and sterling corporate bonds down 7.2% and 6.6% respectively.
This divergence was also evident in styles. Global growth was down 7%, while global value was up 2%. In the IA Global sector, there was a 44.1% difference between the highest and lowest returning funds, the fifth largest monthly difference since December 1999.
Fixed Income – Paul Angell, senior investment research analyst
Among the fixed income managers we interviewed, the long-running debate around whether inflation is structural versus transitory has concluded, with the war in Ukraine seemingly the turning point in embedding expectations of higher inflation for longer. Managers are now focusing on how to deal with this environment, with a spread of views on how best to play it.
The first view is that high inflation leads to higher interest rates, which is bad for duration leading some managers to limit their exposure to interest rate risk and minimise losses as rates increase. The opposing view is that inflation is not being driven by economic strength so central banks should not raise interest rates too high, choking off growth. Managers with this view are increasing duration, believing that in the near-term central banks might lower interest rate expectations rather than continuing to move them higher.
In summary, while there is consensus that inflation, and therefore interest rates, are rising, managers are split on whether markets have over or underpriced the extent of this, thus leading to managers’ positioning accordingly.
Global Equity Income – Jake Moeller, senior investment consultant
Not all companies have been hard hit by macroeconomic events and many global equity income fund managers hold companies that have been focusing on strengthening their balance sheets since the global financial crisis. Such companies are healthy: leverage is at record lows despite the cheap cost of debt, creating a buffer against macro-economic and geopolitical headwinds and many have fared much better than expected during recent market turbulence.
Many managers have a value bias which has been supportive as more defensive companies have held up well. While companies cut dividends, this stemmed more from boardroom fear as managers sought to protect capital flows. Others withheld dividends over concern for their employees, or reduced payments slightly while they assessed the impact of Covid. Fund exposure to dividend cuts was mixed, but it was not generally as bad as might have been expected. Indeed, some companies have a surplus of cash, which they have paid out in special dividends, benefitting certain fund managers.
Some managers have tilted their exposure up the supply chain to avoid inflationary costs.
For example, even if consumers stop buying trainers, a company that sells rubber to the trainer manufacturer can still do well as the pricing power of the upstream supplier is more resilient to both inflation and consumer demand. Others are looking to companies with lower input costs, such as banks to reduce inflation exposure.
Some have shifted their regional allocations. Where they think that European consumers, for example, might come under pressure due to disruptions caused by the Ukraine war, they are investing in similar US companies, where resilience to inflationary and geopolitical pressures is greater.
A pattern is forming around tilts to different regions, different supply chain exposures and increasingly less cyclical exposure and less leverage.
Multi-Asset – Alex Farlow, head of risk based solutions research
Uncertainty dominates conversations with multi-asset managers and there has been a general preference to reduce portfolio risk.
The underlying portfolio changes vary, from reducing equity exposure and/or equity beta with a shift from cyclically sensitive companies into growth-oriented companies which are generally considered more defensive. As some of these were hit hard in Q1, there is a sense of bargain-hunting within equity sectors that are now at more attractive valuations.
Very few managers have significantly changed tack: portfolios have been tweaked although we have not seen major changes in asset allocation. Managers seem to be waiting for greater clarity around news flow over interest rates and inflation before making radical changes.
There is interest in alternatives to counter inflation and exposure to gold has increased. Additionally, several multi-asset income funds hold inflation-linked assets such as infrastructure. We are also seeing an increase in listed property names among some managers and increased exposure to softer commodities and metals.
Value managers aside, there is a preference for US equities over Europe and the UK, based on the strength of the economy and the fact that the US is largely energy self-sufficient and therefore well-insulated from the conflict in Ukraine. Indeed, several managers are discussing potential recessions in Europe and the UK this year.
Another interesting recent observation is that some managers are buying back into government bonds for the first time in years. The US ten-year yield now is yielding 2.9% and in the UK it stands at 1.8%, which some feel is a decent entry point, and if we do see market volatility, it should offer some protection.
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