Eyes wide open – invest with caution in 2022

Asset management
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Markets are at an inflection point as 2021 draws to a close. A growing number of voices are questioning whether inflation will prove to be transitory. There is also uncertainty about the path of economic growth, and whether equity markets can continue to scale new highs. Four Vontobel investment experts outline the challenges ahead and debate the options for investors across equities and fixed income. A balance of caution and risk appetite will be needed to seize the opportunities that await in 2022.

Christel Rendu de Lint, Deputy Head of Investments Vontobel: Inflation in the US stands at around 6.2%, a level not seen since the 1980s. Where do you think inflation and the economic cycle are going?

Mark Holman, CEO of Vontobel’s TwentyFour Asset Management, Portfolio Manager: Inflation is running significantly higher and has been more persistent than even the most aggressive forecasts a year ago. Importantly, it's beyond the levels where central banks are generally comfortable. The US Federal Reserve is clearly focusing on employment and is willing to sacrifice a bit of overshoot on inflation, which will have repercussions as we enter 2022.

Mondher Bettaieb Loriot, Head of Corporate Bonds, Vontobel: From a corporate bond perspective, we remain quite comfortable as indicators suggest that inflation will be transitory. To clarify, transitory – as referred to by Fed Chairman Jerome Powell – means that current levels do not ultimately leave a permanent mark and alter the course of low inflation, or even disinflation, we have seen over the past 25 years.

Christel Rendu de Lint: Matt, what does this mean for equities?

Matthew Benkendorf, Chief Investment Officer Quality Growth Boutique, Senior Portfolio Manager, Vontobel: Patience is required, even though equity investors today are generally quite impatient. I lean towards the transitory camp on inflation because that’s where the preponderance of evidence is pointing. The burden of proof is on the non-transitory side.

Christel Rendu de Lint: Dan, how patient are you when it comes to inflation? And how will you position your portfolio in a multi-asset context?

Dan Scott, Chief Investment Officer, Head of Impact & Thematics, Vontobel: I’m fairly patient. Whether inflation is transitory or not, we all agree that it's stickier than we thought it was going to be 12 months ago. What’s important is that central banks have indicated they're not going to react quickly. In fact, they want to see a better recovery in the job market since real wages and absolute employment numbers are not yet back to pre-Covid levels.

In this environment of relatively low rates, we are looking to equities for returns and other asset classes to help smooth out volatility. We don’t expect investment grade credit or sovereigns to provide much return, although we do see some opportunities in emerging market debt in hard currency.

Matthew Benkendorf: Strong equity market performance has been driven by sentiment as investors have been digesting conflicting evidence as positive. Banks, for example, have had a strong year on expectations of the yield curve steepening, but that doesn’t reconcile with the elevated valuations of many high-growth, unprofitable businesses. We expect increased volatility and uncertainty even as we come through Covid-19. Investors need to redirect their focus away from the short-term, for example the next hot initial public offering, and remember that investing requires patience and time. There's a much wider range of possible outcomes than investors are preparing for right now. The party is still going, but I’d caution investors to drink responsibly.

Christel Rendu de Lint: Mark, how do you look at fixed income portfolios right now?

Mark Holman: I'm not completely in the transitory camp on inflation. There's enough evidence to suggest that inflation will persist. The inconsistencies – 6% growth, 6% inflation and bond yields at current levels – are not sustainable. And inflation is currently eroding wealth.

We've never had this much government intervention and quantitative easing, or interest rates this low before. We expect the Fed to start tightening sooner than investors think in 2022, probably halfway through the year. But in many cases the cycle will be the same as in the past. There will be pressure to see higher interest rates, which tends to mean higher yields. But it won’t peak until well into the hiking cycle.

Fixed income gives you access to many geographies and sectors, but portfolios tend to be focused on either rates (i.e. government bonds) or credit (i.e. corporate bonds). An unhedged "rates" portfolio could be problematic, so investors should hedge if they can. If not, they should diversify across the broad world of fixed income.

In more than 30 years as a fixed income investor, I have rarely seen fundamentals for "credit" look this good. They justify the valuations. The US high-yield default rate is astonishing at less than 1%, and it is the same in Europe. Default rates are going to be slow and there will likely be more credit upgrades than downgrades. That said, I do think the pickings in 2022 will be limited. Investors should be comfortable taking some credit risk but should go into next year with their eyes wide open – as Matt rightly said, drink responsibly.

Christel Rendu de Lint: Mondher, how concerned are you about the potential for policy error by the Fed? And what are your fixed income views?

Mondher Bettaieb Loriot: Frankly, I am not concerned. While we have had a few prints of high inflation, the conundrum is that real yields are still negative. We are living through a digital revolution, with an aging population and rising debt piles, all of which are disturbing. Central bankers have no option but to be patient, even if inflation readings are high. You have to go back to the Civil War in the US, or the Great Depression, to find negative yields events like these. It's quite unprecedented. However, we remain comfortable with the framework provided by central bankers.

I would not be surprised if government yields were lower by the end of next year. Consensus for growth at the end of 2022 is expected to be around 2% – or at pre-Covid levels – while inflation is also forecast to be back around the 2% level by then. We are also some ways away from full employment, so the base case scenario is for the Fed to start hiking rates in 2023, and when they start, rate hikes will not go far. As such, the backdrop is still good for investment grade corporate bonds. Spreads might be a little tight, but they are justified by the low default rates, and besides corporate bonds tend to be much less volatile than other risk assets.

There are still very attractive pockets of opportunity, such as bank AT1s, subordinated issuance from insurance companies, corporate hybrids and BB-rated bonds. And we should not forget "European periphery" corporates at the investment grade level, which pay a little bit more. The European Central Bank still has deep pockets and always buys "the periphery" when it is stressed. So, of course there is noise, but corporate bonds are a little less volatile, and the base case seems to be acceptable.

Christel Rendu de Lint: Foreign exchange markets have been boring for quite a long time but seem to have awakened in this final stage of the year. Dan, what is your view on that?

Dan Scott: The solution to the debt piles is to inflate our way out. From that perspective, it's a race to the bottom among central banks. Then there is a handful of safe-haven currencies that are relative winners. Our financial models indicate that the euro is fundamentally undervalued. However, we’ve been speaking about the need for structural reform in Europe – in areas like labor markets and tax codes – since before the global financial crisis, and it just hasn't happened. That is slowing down growth in recovery periods and explains why European growth is underperforming the US.

We are double-overweight US equities, because we feel that earnings growth at US companies more than compensates for any weakening in the trade-weighted US dollar. Developments in the currency market add an extra layer of complexity for multi-asset class investors. Keep in mind though, that staying invested is the best way to shield yourself from the devaluation of wealth that happens through these inflationary periods.

Christel Rendu de Lint: Gentlemen, thank you very much and see you in 2022.

 

 

 

About the authors
matthew_benkendorf

Matthew Benkendorf

Chief Investment Officer Quality Growth Boutique, Portfolio Manager
About the authors
matthew_benkendorf

Matthew Benkendorf

Chief Investment Officer Quality Growth Boutique, Portfolio Manager
Topics:
Asset management Equities Fixed Income Income Outlook
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