This article written by Iain Lightfoot, Managing Director, Armstrong Watson Financial Planning and Wealth Management and Richard Cole, Fund Manager at Future Money Ltd. Every fortnight we aim to provide you with our commentary on the latest economic and investment developments which are likely to be affecting your investment and pension portfolios.
Iain and Richard also host regular webinars called “Making Sense of Markets” where they discuss the factors affecting economies and markets. Our next webinar in our series is being is 5th August, please click here to register for this event, which will follow a day after the next Monetary Policy Committee interest rate meeting.
In our latest update we comment on how differing asset classes are performing in this current inflationary environment. With this unusual set of circumstances some investors might be finding their portfolios not performing in line with how they expect.
As investment textbooks tell us, the fixed payments of bonds rise in value during an economic slowdown, while equities provide the potential for high returns when the going is good and growth is in play. The pairing of these two broad asset classes therefore creates an attractive basis for a diversified portfolio, as the typically low correlation between the two means that as one struggles, the other thrives. This is likely as close to dogma as exists in any corner of investing, and for good reason, as, over the long term it generally holds true. Portfolios aimed at defensive investors will often have higher allocations to bonds and lower allocations to equities, while more risk tolerant investors will frequently hold higher levels of equities. Many ranges of investment portfolios are constructed aroundthis theme, including that run by Future Money.
To passively follow this rule can, however, lead to unwanted outcomes. While the fixed payments are typically attractive relative to the variable returns of equities when economic output slows, a complicating factor is the presence of inflation and rising interest rates. The returns on bonds typically have no ability to rise in line with inflation and as general interest rates rise, the return previously promised on a bond looks less generous. As such, bonds are often negatively correlated with inflation and interest rates. Equities, however, have a chance of producing inflation beating, or at least, inflation following returns. Not all equities are equal in their opportunities, but those companies with sufficient pricing power can raise their prices to compensate for higher input costs (resulting from inflation).
Where slowing growth combines with higher inflation there is therefore a less clear picture of appropriate portfolio positioning. Bonds would typically do well as an economy slows, but inflation will degrade the relative certainty of their returns. Equities would typically struggle as activity falls, yet, through selective positioning it can be possible to at least partially offset the draining effect of inflation.
These altered relationships mean inflation can lead to disappointing returns for investors who sit in ‘defensive’ funds. There are such examples occurring currently in the marketplace, where some portfolios with higher bonds and lower equity exposures have been falling by more than pure equity funds over the year to date so far, a period when surging inflation has led to fear of an oncoming economic slowdown.
This occurrence may lead some to question the merits of supposedly low risk funds, however, to do so would be to ignore the case that the recent period is a short term occurrence, driven by the relatively unusual combination of high inflation and low growth. Over the longer term, it is likely that more traditional return characteristics will return and the lower equity, high bond portfolios will once again deliver lower risk outcomes.
What’s more, while there have been some fund ranges delivering unusual returns for their risk profiles recently, as traditional relationships between broad asset classes have distorted, it is possible to minimise this impact through active management.
Future Money runs four actively managed multi-asset portfolios with differing equity and bond allocations, each aimed at clients with different investment objectives and risk tolerances. While 2022 has seen falls across each of these portfolios (as nearly all asset classes have lost money this year), those with lower exposure to equities and higher exposure to bonds have outperformed the higher equity, lower bond portfolios. As such, they have performed in line with traditional expectations for lower and higher risk portfolios over this period.
This has been achieved through careful selection of the bonds held in the portfolios. Bonds which mature further in the future tend to have greater sensitivity to movements in interest and inflation rates. This is because the fixed returns of bonds are guaranteed for a longer time: good news if rates fall, but bad news if they rise as an investor is stuck with below par returns for a longer period. As such, if rates are expected to rise, shorter dated bonds will likely fall by smaller amounts than their longer dated peers. Given these dynamics, each of the Future Money portfolios currently have strong biases away from longer dated bonds and towards the shorter end. This active management therefore has moved the exposure of the portfolios based on the conditions present in markets.
Investment markets are going through a difficult period at the moment. Inflation is at 40 year highs on both sides of the Atlantic and central banks must react by raising interest rates. This makes an economic slowdown inevitable and recession is a very real possibility. Yet on the more positive side, the fundamentals of the economy remain resilient: the labour market is strong, companies are still generating reasonable profits and banks’ balance sheets are robust. Once the peak of inflation passes it therefore appears likely that the focus of investment markets will quickly turn to recovery. In the meantime, however, volatility is expected to remain. In some cases traditional investment relationships will remain, while in others distortions will appear. In such circumstances we believe that it is appropriate to remain vigilant to market conditions and to manage investment decisions in an active way, with an appreciation for the opportunities and threats currently in place.
Our expectation throughout this period has been that the regulation brought in during 2021 will eventually be beneficial for the economy, the covid-wave and its lockdowns will pass, and a time for recovery in these areas will come. This period is perhaps now upon us. Covid cases have been falling and lockdowns have now largely lifted. Consequently investment markets are recovering. Of course, if further covid spikes occur then regression could be experienced, but with low valuations across Chinese exposed areas, there is a good case for patient investment in the region, albeit as one part of a diversified portfolio.
Volatility is a part of investing which is why we always take time to understand how much risk any client is prepared to take before investing. We also generally believe in the benefit of diversification of assets to help manage some of the extremes of the markets. Taking a diversified multi-asset approach means that some assets can fair better in different market conditions as they are more defensive assets such as bonds, whereas during periods of growth equities tend to fair better.
Armstrong Watson, in addition to our full range of accountancy services, also have our own fund management expertise from the Future Money asset management team, as well as independent expertise from the wider market. We are able to use this to help provide insight, commentary, advice and support to our financial planning and wealth management clients.
A key aspect of our investment philosophy is that it is time in the market not timing the market, which is usually the best approach. For more information and guidance on Investing, please download our useful Guide to Investing here.
At Armstrong Watson, our quest is to help our clients achieve prosperity, a secure future and peace of mind. We believe that for those people who are considering taking financial advice in relation to their savings and investments it may be a good time to do so to utilise existing allowances and tax reliefs.
Please note that the contents are based on the author’s opinion and are not intended as investment advice. Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise and investors may get back less than they invested.