The key development since our last True Potential Portfolio update has been the Omicron Covid-19 variant.
In the regions Omicron has been identified we are seeing both evidence of and the threat of tighter activity restrictions. This is causing volatility in asset prices as market participants assess the implications for economic activity.
- There has always been potential for new variants to appear, this is the nature of a virus.
- Omicron is believed to be highly transmissible but potentially less severe.
- Vaccine efficacy in respect of the new variant is something we are learning more about, however, the expectation is that vaccines will reduce the severity of illness.
- Vaccines were designed to be flexible around new variants, hopefully limiting the duration of any activity restrictions should they be imposed.
- Globally, we are learning to live with Covid.
In this type of environment, we believe a diversified investment approach across asset class, geographical location and style is prudent to help manage volatility, and to take advantage of opportunity.
Outlook for 2022
As we look to 2022 there are many factors which we believe are supportive of risk assets.
Key examples include:
- Leading economic growth indicators remain robust.
- Consumer balance sheets are healthy supporting demand.
- Corporations are supported by favourable financial conditions and able to absorb higher input costs.
- Evidence that supply chain bottlenecks may be starting to ease, although this could be affected by Omicron.
- Increasing vaccination rates are supportive for maintaining a positive growth trajectory.
The inflation outlook continues to dominate discussion. The main factors contributing to the high inflation readings globally are higher energy costs and supply chains unable to keep up with demand leading to bottlenecks. Our base case is inflation will peak in the first half of 2022 and will start to moderate as supply challenges ease but will sit at the higher end of central bank targets (2-3%).
Wage growth is an important factor to monitor. Compared to pre-pandemic levels, there are currently 4 million fewer people available to work in the US with individuals taking early retirement or unable to work lacking childcare. Should this situation not improve then wages will need to respond.
Consumer balance sheets are healthy, allowing them to absorb higher prices and the appetite to consume remains robust. For corporations, this is beneficial, as they are better placed to pass on higher input costs. This is evident in their reported earnings. Though supply chain challenges were discussed by 70% of the top 500 companies in the US Q3 earnings season, the reports were very strong with 82% of companies beating earnings expectations.
Economic growth expectations remain firm for the coming years, through 2022 we see growth sitting above the longer-term trend offering opportunity for economically sensitive assets, therefore we are happy to maintain a tilt towards cyclical assets but anticipate the rate of positive change to start to moderate through the year.
In terms of investment styles, should inflation moderate and economic growth remain strong, we believe assets which are more economically sensitive are appealing. We capture this within the True Potential Portfolio proposition which has a natural style bias towards value. However, diversification of style is important and we have exposure to various style and implementations in the portfolios.
We have passed an important inflection point. Central banks around the world are at differing stages in their monetary tightening cycle. The US Federal Reserve has begun to reduce the rate of bond purchases, reducing the available liquidity. The Bank of England have begun their rate hiking cycle. In contrast the European Central Bank remains more expansionary from a policy perspective, and the Peoples Bank of China has recently moved back into easing mode. Given we are in an environment where on a regional level we are seeing yields move higher, we remain underweight bonds relative to an equally weighted portfolio.
- We remain positive on risk assets – expressing this through a mild overweight to equities but recognise there are near term risks.
- Maintain a diversified approach, a bias to a valuation opportunities in economically sensitive assets and a mild skew away from mega cap growth stocks that are more sensitive to upwards shifts in bond yields.
- Underweight bonds in an environment where inflationary pressures are proving more persistent and recognising that absolute yield levels are low relative to history and real yields are negative.
- Favouring alternative assets, providing defensive characteristics with low correlations to equities and bonds, along with the expectation of better risk adjusted returns compared to bonds.
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