After years of low inflation and low interest rates, we have finally entered a new period in the economic environment of higher inflation and higher interest rates. But how high will inflation be and by how much will interest rates rise? Periods of transition from a market perspective increase uncertainty and subsequently increase market volatility.
From a dynamic asset allocation perspective, over a number of years we have built up our exposure to real assets and have included alternative assets such as gold, as inflation risk was growing. While we have maintained an underweight exposure to fixed interest, we have ensured that our exposure to the sector has been diversified which has become increasingly important as bond yields continue to rise. The rise in bond yields will means that at some point the yields on offer will become attractive again and warrant an increase exposure. It is fair to say that we believe the coming period will be one where bottom up investment selection will be a key contributor to performance compared to the recent past which has been dominated by low interest rates and ample liquidity which supported a strategy of being long equities and short bonds, which drove performance for many strategies.
From a bottom up perspective, we have seen extreme market activity. On the equities side, the winners have been largely concentrated to those parts of the market that are expected to benefit from a higher inflation environment such as energy and resources. This market environment has seen value style managers outperform growth style managers in recent months, as any long duration investments such a growth equity stocks, which are priced for future growth, have been sold down irrespective of their quality. While the performance of growth style investments has been disappointing, we don’t think it is the time to throw the baby out with the bath water. The market has already pulled back and provided companies are supported by earnings and have solid balance sheets, a long term allocation to growth is still warranted as part of a diversified portfolio. Similarly, on the fixed interest side, bonds have sold off as bond yields have risen. Clients are rightly nervous about their portfolio bond allocation, however if we look forward, bonds are looking much more attractive now on a forward-looking basis than they have in a while.
In volatile times, when returns can look ugly, it is tempting to be reactive and want to sell the ‘losers’ however markets are forward looking and it is important to consider what is already priced into the market. Challenging times ahead but history tells us that market pull backs tend to be sharp but also generally don’t last long.
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