Investor Insight, March 2022

In discussions with our asset allocation consultants, Heuristic Investment Services, there have been some changes to our asset allocation as reflected in the table below.

Tactical Asset Allocation: Quarter 1, 2022      

For the first time we are neutral listed markets, and we believe this needs explanation.

Our rationale is separate from the conflict in Ukraine, which we will discuss later in this Insight.

The speed of the current cycle post the COVID selloff in 2020 has been unique.

Looking back, the fast pace of the recovery has been staggering. So too will be the overall length of the cycle as we roll forward. We must ensure we stay on track to maximise returns and balance risk.

HISTORY

The post Global Financial Crisis (GFC) cycle was a longer or slower cycle than normal, starting in early 2009 when global GDP for that year was just 0.1 per cent – rotating on until the beginning of 2020.

The trigger for the GFC was the call-in of US sub-prime loans and collaterised debt obligations – and a sharp market correction. However, what was most striking about the decade following the GFC was the low productivity gains. Global GDP averaged about 3.8 per cent, with the US at around 2.7 per cent, Europe at around 2.1 per cent and China driving global GDP at around 6.5 per cent.

THE PRESENT

Now, two years after the COVID- induced recession, the International Monetary Fund sees global GDP as moderating in 2022 to 4.4 per cent, down from 5.9 per cent in 2021, having contracted -3.3 per cent in 2020.

Considered against the GFC global GDP numbers, these are remarkable figures. What is most striking is that this is happening when we have now entered late mid-cycle.

The key issue is the policy setting for the early stages of the recovery. Central banks are taking longer to start raising interest rates. Policy tightening is later into the cycle than is normally the case. Central banks are aiming to get policy settings to a neutral setting – waiting for full employment rather than tightening ahead of inflation.  An impact of this approach is that they are therefore ‘behind the curve’.

Why are we in this stage of the cycle?

The first key reason is the COVID-19 pandemic itself and the shakeup it has caused, triggering uncertainty and market disruption; the second is the response by both governments and central banks. They responded with a massive loosening of fiscal and monetary policies. That has challenged traditional thinking around responding to market disruption and, in some cases, has wrong footed investors.

In terms of outlook, 2022 will continue to be bumpy. That means strong discipline in asset allocation and diversification will be rewarded.

The reason for our neutral stance for Risk assets though is the balance between risk and return. We have often mentioned that we always focus on “risk” when we assess asset allocation.

To put this simply, the risk/reward tradeoff has brought us to a neutral position on listed markets.

LOOKING FORWARD

Whilst the discussion on inflation is making headlines today, that topic isn’t new. Inflation has been with us for four to five months, however Capital Economics recently noted, “we’re at the point where the pressure on central banks to act is at its greatest.”

We expect inflation to remain elevated for now, especially in the United States, where it will hold at or around seven per cent for the next few months. The second half of the 2022 calendar year will likely see inflation decelerating towards four per cent.

Cash rates in Australia are factoring in 1.0 per cent for year end 2022 with 1.75 per cent for the third quarter 2023 (presently 0.1 per cent). In the United States, cash rate predictions are for 2.0 – 2.5 per cent for the end of 2023 (presently 0.25 per cent).

Interestingly, Capital Economics see the Ukrainian conflict making “a 50bp rate hike (in the US) in March even less likely though we still think it will raise rates four times this year. Looking further ahead, the balance of risks could shift back again later in the year if the threat to economic activity in Europe fades and US equity markets recover”.

Sadly, the speculation about war in the Ukraine is now fact. In the past, geopolitical conflicts have provided a buying opportunity. We believe this will again be the case but the key economic determinants need to be looked at.

A market response of a sharp selloff followed by a strong bounce is not abnormal, but we prefer to act on facts.

Our job as a wealth manager is to avoid traps, and we believe performance over the next twelve months can be maximised through the traps we avoid more than anything else.

One of these is index investing. What is certain is volatility and with index funds you will be fully exposed to this volatility. One thing we constantly measure is the volatility of our portfolios against both benchmarks and competitors and we are proud of this lower volatility.

Over the next twelve months we believe that conviction management in listed markets will deliver strongly over index management, as inflation and interest rate fears add to volatility and we see both over and under reactions in markets.

These markets are not about buying the indexes and hoping they rise. This is about buying companies that will see strong earnings growth and, more importantly, avoiding the losers. We have a heightened awareness of our fund manager selection and their performance, which we are monitoring closely.

It does amuse us to see the long/short funds come out of the woodwork and start to contact us however, we stick with our view that in the medium to long term there is only one winner with these strategies and that is the fund manager.

With respect to the Ukrainian conflict, Russian markets are the big losers and are in complete meltdown. Last Thursday the Moex index in Moscow briefly fell -45 per cent, closing at – 33 per cent down and the Rouble fell to a record low against the USD. Even Oil and Gas majors plummeted with Gazprom falling – 37 per cent and Lukoil -34 per cent. The most volatile was the London listing of Russian stock Sberbank through a global depositary receipt, down 72 per cent at one stage.

As a foot note these stocks have since rebounded but this is a key reason why some fund managers we use will not invest in Russia due to sovereign risk. Capital Economics estimate Russian GDP to fall by 1 per cent based on the effect of sanctions, and their policy rate to increase from 9.5 per cent to 12.00 per cent.

THE CORE

Back to the core things we are looking at, and that is inflation and interest rates. The uncertain outlook there is why we made the asset allocation changes we did.

We don’t believe the conflict will make central banks delay raising interest rates and our reasons are:

• Capital Economics see oil trading between USD120-140 per barrel butdespite a spike in Gas prices also, demand will fall as Europe goes into spring leading to a downward price correction  in Q2.
• Capital Economics see wheat prices increasing by 25 per cent due to the effect of the sanctions.
• Capital Economics see inflation about 1 per cent higher than under “previous energy forecasts in the near term, leaving it averaging 6% in Q2 rather than 5%.”, and developed market inflation could still be 4 per cent by calendar year end.
• Policymakers will be weighing the upside risks to inflation against the downside risks to activity. The conflict will not derail plans for policy tightening this year, but the events of the past week have tipped the balance towards erring on the side of caution.
• Importantly on sentiment and confidence, Capital Economics see “a small adverse effect on business confidence and GDP growth in the major advanced economies and supports our instinct that while inflation tends to rise following such crises, central banks typically set policy somewhat looser than they would otherwise have done”.

There are those who are predicting even higher inflation however we highlight the four factors which Capital Economics points to and which are highly relevant in our local market:

• Falling inflation – likely to fall over the course of 2022, “as energy and goods inflation ease and the immediate inflationary effects of the pandemic fade”.
• Easing supply constraints – as economies reopen, supply constraints will ease especially in 2023.
• Low rates – neutral real interest rates remain low and therefore it will not take much to cause policy settings to have an impact.
• Evolving monetary conditions – how monetary conditions will affect the real economy is a key question. Heuristic argues that cash rates may have factored in too much for the effect in the real economy to have an impact.

Economically there is robust ongoing growth out of a very strong recovery.

Australian equities should do well on a relative basis due to index composition however they have lagged developed markets. Australian equities were up 9.61 per cent over the twelve months to the end of January 2022 whereas Developed Markets (MSCI ex Aust) were up 18.58 per cent hedged and up 27.3 per cent unhedged.

Emerging Markets historically do better in these times but they have also lagged, up 1.03 per cent for the twelve months to end of January 2022.

Our Developed Market equities allocations has been reduced through a decrease in US equities. The US is approximately 53 per cent of the MSCI global index, therefore an underweight in the US has a significant impact. We have monitored fund managers to ensure they are overweight Europe and the UK.

REITs have been downgraded based on relative value and lower real yields.

Core asset allocation holdings such as infrastructure should be central in a portfolio.

As we roll forward our focus is to stay on track to maximise returns and balance risk and ensure portfolios are diversified with a strong discipline in asset allocation.