What happened in 2021?
2021 was a strong period for financial markets, particularly growth assets such as equities. However, we did see weakness in those more defensive and interest rates sensitive sectors, with bond markets weaker. This was on the back of rising bond yields through 2021, and highlights the challenges associated with defensive assets in a rising rate environment. However, when we look at the start of 2022, markets have been more volatile with equity markets sharply lower, while bond markets have also struggled. In part, we view this as part of an equilibration of financial market performance given what we have witnessed since 2019. If we consider the start to 2022 in the context of very strong performance returns across multiple asset classes since 2019, we do not believe that the challenges of January are out of sync relative to any other market pullback. From an investment standpoint, we feel it’s important to appreciate the need to balance return expectations and understand that markets cannot continually deliver double digit returns, particularly in periods where the earnings outlook is moderating.
With inflationary expectations rising around the world remaining higher than central banks would like to see, we’re now in a market environment where rate rises are on the cards. Already we have seen the BoE and RBNZ increase official cash rates and in our view the US Federal Reserve will begin the process in March.
Higher cash rates and bond yields will have implications right across the world for financial markets and this is what we are seeing (in January) with the repricing of risk in those parts of the market that are sensitive to higher bond and real yields. This is starting to play out most notably in the tech sector, particularly around companies with excessive valuations, which is impacting market performance over the first few weeks of January.
A more challenging investor market to come
When you look at the performance that we’ve seen over the last couple of years, and we look at the earnings growth going forward that we expect in financial markets through the course of 2022, we don’t think that this recalibration of equity markets will be the norm. However, we believe that market volatility will be elevated throughout this calendar year as we are going to be in a rate rising environment, impacting bond yields that will ultimately also impact other asset classes (such as equities).
In addition, when considering the defensive part of the market such as Treasury based securities, whether it be Australian or Global, in our view investors are looking at negative returns for those asset classes at this stage of the cycle Accordingly, on a relative basis we remain overweight growth assets but we’re mindful of the ‘type’ of growth assets that we want to add into our portfolios. In our view, it’s all about quality and not being overly aggressive in asset allocation positioning.
We’ll also be looking to invest in assets that can take advantage of higher inflationary expectations if that continues to remain elevated throughout the course of this year including investments that have floating rate cash flows that can benefit from higher inflation over the journey.
As we head into 2022, we haven’t made any material changes to our portfolio positioning. We are sensitive to the fact that we are likely to be in an environment where interest rates rise throughout the year and central banks are turning off a liquidity tap, therefore that will shape how we think about investing in 2022.
At this stage we don’t expect any changes in RBA policy throughout the course of 2022. However, financial markets may start to price that in and we may see domestic yields continue to move higher, as they have through the month of January. This will prove to be a challenge for both domestic fixed income and equity markets.
Recalibration in our view is something that investors need to be mindful of. When comparing the performance from the last three years which was positive for risk assets, we believe that the overall profile that we’re seeing and the recalibration and repricing of risk in equity markets in not of sync with what we’ve seen previously in financial markets.
We expect this period to be challenging for investors, particularly those that are just going into the market as defensive assets are also likely to be under pressure, however, we don’t expect the month of January to be the norm throughout the course of this year. But we believe it does highlight that investors need to focus on having a broad, well diversified strategy. Investors should continue to maintain a focus on what markets have done over the journey and balance those portfolios and asset allocation framework akin to the risks and return profile associated with those underlying investments.
Piers Bolger is Chief Investment Officer at Viridian Advisory.
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