Client Update - 14th January 2022
Already in 2022, markets have quickly shown us that there is much to consider this year. Away from hearing about bring your own booze political “work” functions, our focus coming into 2022 was on the key risk that we have all mis-priced the monetary policy cycle, meaning rates will go higher more quickly than was thought. The minutes from the last Federal Reserve (Fed) Open Market Committee, which were released on January 5th, underlined that risk. They more than hinted that rate hikes could start sooner and that the central bank’s balance sheet could be reduced more aggressively. While this says nothing about the end-game of the coming monetary policy cycle – the Fed’s terminal interest rate forecast is still 2.5% – the journey there could be bumpier.
One of the factors to be aware of in a rate rising cycle, is the effect on bonds. As interest rates increase, bond yields tend to rise and this leads to a loss in capital for bond investors. As you will be aware, bonds form a key part of a portfolio for both long term return but also diversification purposes. For now, we expect that bond returns will struggle until the markets have settled on a new consensus for the path of rates. Of course, the Fed is not the only story in town here as the Bank of England has shown in December.
If 2022 was nailed on as a year of continued economic recovery in the face of a receding pandemic and easing of supply disruptions and labour shortages, then confidence in the path of interest rates would be higher. However, we remain in the midst of a fourth wave of the pandemic, albeit this one is being dealt with differently. While hospitalisation and death rates are lower than in previous waves – thanks to vaccination programmes – there is still disruption being done. Note the widespread cancellation of airline flights over the holidays and the shortages of public sector and other workers being reported in many economies. This is bound to create some downside growth risks in the short-term. In addition, there is no let-up in the global surge in energy prices. This tax on incomes will add to the growth uncertainties. So even though bond markets are super-sensitive to central bank messaging and have priced in more in terms of rate hikes than was the case a few weeks ago, there has to be a scenario in which the normalisation of policy is delayed. We certainly continue to live in interesting times.
All of this creates uncertainty. Bond yields have risen to their 2021 highs. For those investors concerned about growth and the ability of equity markets to sustain the performance of the last two years, earnings momentum and revisions data suggest a 5%-10% total return expectation is reasonable this year. The most recent data from analysts is more negative in terms of EPS growth for Europe relative to the US but it remains the case that the US market is more highly valued. We have spoken before that the rise in bond yields may force some re-ratings of the more expensive equities such as technology – this is perhaps already happening in 2022 at the index and sector levels.
Much to think about therefore in the year ahead, but also many positives to explore. There are many mega-trends that will drive equity returns over the coming years, mostly centred around de-carbonisation, further digitalisation and social considerations (healthcare, leisure, new trends in work-life balance). As always with investing, it depends on your time horizon and your risk tolerance and this is something that, as always, we are here to advise our clients on. Have a lovely weekend.