Chris Leyland, True Potential Director Of Investment Strategy, looks back on the key themes around the True Potential Portfolios over the past month
We remain positive on risk assets for the following reasons:
- Monetary tightening has commenced in the developed world. However, financial conditions remain favourable.
- Scientific evidence suggests the time to reach herd immunity of the Omicron variant in countries with higher vaccination levels is faster and symptoms are less severe than previous variants, leading to the potential for lower/less prolonged activity restrictions.
- Economic growth is forecast to be strong for 2022 into 2023.
- Corporations are in a better place to pass on or absorb higher costs given consumer demand and healthier corporate balance sheets.
- Evidence that supply chain bottlenecks may be starting to ease, although this could be affected by Omicron, particularly in China.
Tightening of monetary policy has begun or is about to begin in many regions. In the US, market expectations are for four/five rate hikes this year with the first hike in March. So far this year, a tightening cycle has led to uncertainty. With high growth equities more sensitive to rising interest rates as their valuation depends heavily on future earnings, a rise in long-term yields cuts the present value of companies’ future earnings. Higher interest rates have offered opportunities in other sectors. Financials have enjoyed a relatively strong start to the year compared to other sectors, buoyed by higher rates leading to the potential for higher profits.
Near zero interest rates are not normal. Interest rates are moving higher as we continue the recovery trajectory. We believe the global economy is strong enough to withstand higher interest rates. We understand there will be uncertainty as investors adjust to this new environment. This illustrates why diversification is so important.
Omicron dominated our previous report. The picture is now much clearer. Studies have shown Omicron to be more transmissible but less deadly. Investors are looking through the Omicron strain back to an environment of strong demand leading to robust economic growth. Omicron has led to some of that growth being delayed but we view this as a deferment rather than an loss of output.
Different countries have dealt with Omicron in differing ways. The developed world has generally kept stringency measures low, particularly the US and UK. However, looking East, China has continued to pursue a zero-Covid policy with Beijing looking to prevent any large scale transmission of Covid-19, particularly as it hosts the Winter Olympics. Depending on how this develops, supply chains could be affected in the short term.
Growth expectations remain firm for the coming years. Through this year we see growth sitting above the longer-term trend with Bloomberg consensus estimates for global growth 4.3%. In terms of styles, should inflation moderate and economic growth remain strong, we believe assets which are more economically sensitive are appealing. We are capturing this within the True Potential Portfolio proposition which has a natural style bias towards value.
Inflation readings have continued their upward trajectory with US CPI for December 7% year on year pushing higher from November’s 6.8%. The UK has followed suit with CPI year-on-year at 5.4%, above November 5.1%. The main factors contributing to higher inflation on a global basis are higher energy costs, shelter, and supply unable to keep up with demand leading to bottlenecks.
In the US, a key discussion point is owner equivalent rent (OER) and how this factors into inflation calculations. OER is the amount of rent that would need to be paid to substitute a currently owned house as a rental property. It is a large part of the US inflation calculation, 1/3 of Headline CPI and 40% of Core. The past strength in the housing market means OER is forecast to increase by 5%+ during 2022, potentially leading to inflation remaining higher for longer than initially thought. Wage pressures continue building particularly in the lower income cohort. Our base case remains inflation will peak in the first half of this year and will start to moderate as supply challenges ease. However, the rate of deceleration is unclear and we believe inflation will land at the higher end of central bank targets (2-3%). The risk to this forecast is skewed to the upside.
On a different trajectory to many developed market central banks, The People’s Bank of China (PBOC) has started to increase stimulus, lowering the interest rate on short to medium term loans. Both Chinese equity and credit struggled during 2021 with China’s policy to reduce wealth inequality policy hitting many sectors.
Emerging market assets are becoming more attractive with some of the True Potential manager cohort discussing adding to positions taking advantage of cheap valuations compared to both history and developed markets. Others are waiting, unwilling to commit until there is more visibility on future policy in China.
Asian high yield bonds are in focus. Moves in the Chinese property sector dominate sentiment with nervousness that contagion is spreading to the larger, better capitalised companies and the potential the Chinese government will not provide enough support. For some, this is an area that is being reduced or removed whilst for others spread levels, the amount of extra yield demand over government bonds, are so wide as to offer opportunity.
Within fixed income, we remain underweight, cautious Central banks are on a pathway of tightening. In a rising yield environment, we favour shorter duration positioning, less sensitive to higher rates, and hold longer dated issues for risk mitigation purposes. Investment grade paper is unattractive relative to equities, held to provide income above sovereign issues, but the opportunity for yields to compress is limited.
< Back to Blog