To date, 2022 has been dominated by a negative news flow. The crisis in the Ukraine, Central Banks behind the curve in dealing with inflation and extreme pressure on the day to day cost of living. Given all of this, on a relative basis, portfolios have been holding up relatively well considering the broader context: decades-high inflation and the most radical pivot toward tighter U.S. monetary policy since 1994. This has produced the worst rout in U.S. Treasuries (bonds) in 50 years and sent short- and long-term bond yields surging. Given all this, one might expect portfolios to have struggled to a greater extent.
It is an often used phrase that in worrying times, it proves to be darker before dawn and in this context perhaps markets have been over-reacting to the news at hand. There is every chance that year on year inflation will gradually start to turn down as energy price rises slow, however much of this does depend on the outlook from the Ukraine. This may result in the US Federal Reserve (FED) adopting a more reserved rhetoric that the Bank of England have moved towards – resulting in an interest rate rise on a slower trajectory than markets are now expecting. Perhaps even the FED will not need to unwind its massive balance sheet as aggressively as once thought. Recent economic data suggests that goods-related inflation is appearing to ease, and “core” inflation, which excludes energy and food, recently came in lower than expected. But we should not write off the potential for persistent inflation. Rents are still growing, and inflation in services businesses, especially linked to travel, is significant. Also, the intensification of the Russia-Ukraine conflict leaves little room for relief in rising energy, metals and food prices, while the renewed COVID-related shutdowns in China are re-igniting supply chain-related price squeezes.
Today’s economic fundamentals are different from the prior cycles, and investor portfolios should change, too. We remain confident in diversification by asset class, region, sector, style and market capitalization. We recommend this in the face of a difficult short term investment landscape. It is not clear that we have yet reached peak central bank hawkishness. The hawkishness of central bank rhetoric in the US has been ramped up in the last few weeks and talk of one or more 50 basis points (0.5%) hikes in policy rates has become commonplace now. Indeed, in the US, current market pricing is for a 50bps hike at each of the three upcoming FOMC policy setting meetings – May 4, June 15 and July 27. By then the Fed Funds rate could be 1.75%. We have a suspicion that this may be a little too aggressive given slowing global growth and any reduction in this path of rate rises would help equities.
We cannot deny that investors are being squeezed by rising prices and that is already evident in consumer confidence and spending data. UK retail sales growth was -1.1% (excluding motor fuel) in March. Retail electricity prices in the UK are expected to be close to 50% higher on average in 2022 compared to 2021. It’s clear to see that rising prices for life’s basics will mean less spending on more discretionary items. Hence the underperformance of household goods, autos and retail in the UK equity market this year. There is unlikely to be a UK consumer spending boom anytime soon.
In contrast, companies with strong pricing power and high barriers to entry for competitors can continue to do well in the face of higher inflation as they have the ability to pass higher costs onto customers to maintain their revenue stream. These are the companies that we continue to favour, whilst looking for opportunities to increase exposure in areas of the market that have been excessively punished in recent months. If ever there was a time for active portfolio management, this would appear to be it.
Please do have a good weekend, and as always, should you have any questions, please do not hesitate to be in touch.