Tales of the unexpected
06 July 2022
After an extremely uncertain start to the year in financial markets, the rest of the year may be little better. As the war in Ukraine rages on, inflation surprises on the upside, and hints that central banks may lift rates quicker than expected, the rest of the year seems likely to be a volatile one. So, what can investors do?
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- With financial markets all over the place, the correlations between asset classes changing and a striking lack of visibility on the outlook for companies, volatility has been the word so far this year. It looks like continuing to dominate the market mood over the rest of 2022
- Diversification is key in volatile markets. However, it may be time to broaden horizons when it comes to allocating assets as the traditional approach of investing 60% in equities and 40% in bonds struggles to produce desired returns. Private markets are one potential source of additional returns
- As central banks aggressively lift rates to fight inflation, rising yields look set to create opportunities to lock in rates this year. Among fixed income segments, BB-rated bonds appear to offer the most attractive risk-reward
- In equity markets, although earnings expectations may be too rich, upcoming earnings downgrades are already reflected in valuations. In coming months, we see opportunities in both cyclicals (banks and industrials) and defensives (healthcare)
- The long-term, secular themes of rising digitisation, transitioning to a low-carbon world, and revamping infrastructure can offer investors some respite from the current turmoil in markets
After more than a decade of ultra-low interest rates and weak inflation in the developed world, the sight of surging commodity prices and rate hikes by the US Federal Reserve and Bank of England has shocked many investors. Add in Russia’s invasion of Ukraine and a weakening outlook for economic growth and it’s been a tough time for investors.
More challenging times
With financial markets all over the place, the correlations between asset classes changing and a striking lack of visibility on the outlook for companies, volatility has been the word in the first-half of the year. At such times, diversification comes into its own more than ever. However, with the traditional asset-allocation approach of investing 60% in equities and 40% in bonds struggling to produce desired returns, investors may prefer to diversify beyond such a strategy.
What next for investors? The macro backdrop has clearly deteriorated. We now expect to see lower growth and higher inflation over the rest of the year. It may be a surprise to see central banks in hawkish mood given the growth outlook, but policymakers will be keen to restore credibility in their fight against inflation before confronting weakening economic momentum.
Despite the dire mood being seen in investing circles, our outlook remains as constructive as it was at the start of the year. Growth is slowing and may fall into retreat, for a short period, in parts of the world. However, we forecast that global growth will be better than trend this year and next. Similarly, while inflationary pressures have been stronger than expected so far this year, their peak seems close. All in all, the data suggest the worst may be behind us.
Given the poor investor sentiment, much bad news seems already priced into risk assets. Markets tend to be forward-looking ‘machines’, where the rate of change matters far more than the level of asset valuations. Encouragingly, slow but steady growth tends to be much more supportive for markets than growth that may be high, but is slowing.
Look to the long term
Unfortunately, it will take some time for the mists of the current market, geopolitical, and macro uncertainty to lift. None of the problems on the radar of investors – the risk of a policy mistake, the effects of geopolitical tensions, or the slump in China – seem to have a simple, short-term solution. Indeed, it is likely to take some time, possibly into next year, before investors become more comfortable around these issues. As such, market volatility looks like remaining elevated.
In this context, it’s critical to keep focusing on long-term plans and goals when allocating a portfolio, rather than giving in to any urge to change course in search of a short-term fix.
Achieving investment goals in tough markets
Unusually, both bonds and equities are in negative territory so far this year, adding to the turmoil facing investors. While both asset classes should recover, especially as the market and macro outlook clears, searching for extra sources of returns outside of them seems preferable at such times.
In the bond world, rising yields look set to create opportunities to lock in rates this year. Among fixed income segments, BB-rated bonds appear to offer the most attractive risk-reward.
Turning to equities, volatility seems here to stay until the growth and inflation mix turns for the better. Although earnings expectations may be too rich, upcoming earnings downgrades are already reflected in valuations. In coming months, we see opportunities in both cyclicals (banks and industrials) and defensives (healthcare).
Among extra potential sources of returns, investing in private markets is one avenue that springs to mind. It may appear daunting to invest in this asset class, given that it would involve giving up portfolio liquidity. That being said, doing so can boost returns (due to the illiquidity premium earned on assets that take longer periods to liquidate) and avoid making impulsive and possibly ill-advised investment decisions.
Similarly, long-term investment themes can offer pockets of calm amid the turmoil. The events this year may have increased the emphasis put on power and food security by governments, creating fresh opportunities for investors. That being said, energy transition to a low-carbon world, the increasing digitalisation of our economies, or revamping infrastructure, offer long-term, secular themes set to change the world while providing a source of both returns and peace for investors.