Look back on the past year and investors have, on the whole, enjoyed strong returns. It has been a pleasant ride too over the past 3, 5 and 10 years, punctuated by the odd phase of volatility and one significant market crash brought about by the onset of the pandemic. However, those able to turn a blind eye to day-to-day volatility have been rewarded.
More recently, we have entered a quieter phase. Share markets have been edging upwards and there has been a bit of a swing in focus at times to areas previously left behind such as energy. In bond markets there has been a bit more action as investors grapple with just how much inflation might be around the corner. In the short term, inflation has been surprisingly high, but that’s a blip according to central banks. They urge that prices should level off as we move into 2022 as pandemic-induced supply constraints are behind us – and bond markets are so far concurring. Medium to longer term bond yields haven’t moved that much.
Some investors are worried that high energy costs, shortages of various goods and services and a tight jobs market could stick around for longer than anticipated, continuing to push up prices. Among several challenges, the most significant factor holding back the economy now is a lack of workers, a problem that is likely to be resolved with higher wage growth – which is inflationary.
Projections made in September indicate that nine members of the Federal Reserve’s rate setting committee now expect core inflation for 2022 to be above 2.3%. Assuming that the median forecast proves correct, this would follow a 3.7% rise this year. Can inflation that is meaningfully above its target for at least two years be defined as ‘transitory’ as central bankers often describe them?
Higher inflation and higher interest rates to combat them is a potential headwind to bond markets. Swathes of the Bloomberg Barclays Global Aggregate, the most referenced bond index, provide yields of less than absolute zero (20%) or below 2% central bank inflation targets (76%) as of 30 September 2021. Furthermore, yield hungry investors have pushed the yield ‘spread’ of the lowest rung of US investment grade credit (BBB) over US Treasuries to their leanest ever level.
Any central bank with the nerve to raise interest rates could cause a rather uncomfortable ride for those in the 40% bond portion of the classic 60:40 portfolio that has so far stood the test of time. Most investors have limited experience of dealing more inflationary periods and no recent data to guide the repositioning of their portfolios in the face of heighted inflation, if indeed that does transpire.
What’s more there is a potential knock on impact on equities too. That’s because company earnings, are priced partly with bond yields as a yardstick. The higher inflation, interest rates and bond yields are the less future profits are valued at in today’s terms.
Are investors too nonchalant?
Periods of calm in markets have a habit of morphing into more unstable periods, and with the growing inflation risk in mind it may be a good time to build resilience into portfolios, especially as there seems to be a significant degree of exuberance and speculation in markets.
The boredom of pandemic lockdowns and volatile markets have inspired more people to get involved in investing – though much of the activity out there is better described as ‘entertainment’ than ‘investing’. There are plenty of expensive assets with little or no intrinsic value, buoyed by speculation, social media memes and ‘FOMO’ – Fear of missing out. Despite having zero revenue, US electric vehicle newcomer Rivian has a valuation exceeding Volkswagen, which likely has the capacity to manufacture many times the number of vehicles. This is just one example of narrative seemingly trumping value in the current market.
A tipping point can only ever be seen in retrospect, but it seems likely that the easy profits of the past couple of years, when pretty much everything went up as money was printed, will at some point ebb away. The investment landscape will change, markets will become more volatile, and it will just get more difficult. Those taking on too many risks in the same direction could face a tough time, and it may be necessary to think harder about how to construct an investment portfolio.
How can investors adapt? We believe in being risk aware, selective in terms of asset selection and nimble enough to take advantage of opportunities as they present themselves. Diversification is vital, but it has to be the right kind of diversification.
Building a central scenario and accepting that this might be wrong is the first step. It’s better to be ‘about right’ consistently than alternate between being absolutely right and absolutely wrong. It should mean less portfolio volatility and better enable returns to compound consistently over time. This calls for a portfolio that is made up of assets with varying characteristics and driven by different trends.
If you don’t have time to manage your investment selection hands on, one option for spreading risk and harnessing a diverse, portfolio selected by experts is our Multi-Asset Fund range.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
Are the easy times behind us?
Read this next
Pandemic savings to boost Black Friday, but what then?See more Insights