It is widely expected that central banks will push up interest rates in 2022 and this has been the main driver on markets,
both bonds and equities. There are only a few reasons why central banks want to increase interest rates; inflation, growth and unemployment.
As we have seen from recent headlines inflation in developed markets is at the highest levels for decades. In the UK, Consumer Price Inflation (CPI) is currently 5.4% and expected to pick up over the coming months. As already mentioned, this is a global backdrop and US CPI is currently 7.1%, while in Germany CPI is 5.3%. This is because global demand is accelerating as consumers rush back, but supply chains are currently unable to cope.
Economic growth has bounced back strongly, and most economies are now back to, or greater, than their preCovid levels. Increasing interest rates should be seen as a positive because it means that Central Bankers believes the economy is strong enough to withstand higher borrowing costs.
Finally, employment levels have recovered to their preCovid levels in most major developed markets. The speed of the labour market recovery has been quite sensational. It took seven years for unemployment to fall to these levels after the last recession (the financial crisis); it has been achieved in just 18 months in this recovery.
Despite the fact interest rates are moving higher, we are not expecting them to go back to the level we have seen over the last 40 years because the environment is now different. We remain a highly indebted world and an increase in interest rates will have a huge impact on government finances. In the UK, a 1% increase in interest rates accounts for an extra £25 billion in annual interest payments for the government. This means that the sell off in government bond prices is unlikely to be a sustained sell-off because interest rates won’t drift higher and higher.
To provide some comfort on the environment we are going through, we thought it is worth highlighting that we have been here before, and relatively recently;
We went through a similar fall in government bond prices this time in 2021. Last year, investors were concerned about economies reopening and the possibility of higher levels of inflation. This means government bond prices fell initially, as they were sold off, and then recovered. This year we fully expect a similar scenario, markets are moving in anticipation of
the Federal Reserve meeting in March, which is when investors expect the first interest rate hike. The stability in prices will come around Federal Reserve meetings. There’s actually one happening this week which could
provide some comfort to investors.
Technology and Growth equities are most impacted in this environment. The sell-off in government bonds has spooked high growth companies which can sometimes be priced off a discount rate. Investors look to discount future cash flows to a value today. As bond yields increase, so do discount rates which means the present value of these businesses is smaller i.e. the current value of the company is deemed to be lower and consequently their share prices fall. Again, we saw the same environment in 2021 when share prices fell initially but recovered as the year progressed.
Sadly, we have seen political instability impacting markets. This always has a quick and negative impact on markets as it reduces confidence in global growth and investment markets. Since every war/political event, markets have always staged a recovery.
A correction is common and healthy in markets. A correction ensures animal spirits do not run away and from a Luna perspective it often throws up a number of stock or asset class opportunities. Corrections are also very common, the S&P 500 averages at least one 10%+ pullback per year. In fact, that type of pullback occurs, on average, every 222 trading days. This bull market has not had one since it started—over 450 trading days— so it may be due for another retreat in the near term.
How are Luna positioning?
We feel relatively well positioned for the current environment. We have a low allocation to cash which in real terms is losing pace with the current high levels of inflation. We also have a low allocation to government bonds which are falling in value given that central banks are changing direction. Within our equity allocation we are well balanced across styles (Value and Growth). Over the last 18 months we have been reducing our exposure to the US, Growth and Technology and favouring companies that can benefit from an economic recovery (Value). The latter companies, the Value names, have performed better in recent weeks. The Financial sector tends to perform relatively better when interest rates are moving higher. Equally, commodity prices have also been well supported in 2022 and our exposure to Oil and Miners has helped portfolio performance.
Financial, Energy and Basic Material companies tend to have a greater exposure in UK and European stock markets compared to the Technology heavy US stock market. We have had a bias to the UK since the Luna outset because valuations are more attractive. This has helped in the short term.
What have Luna been doing?
When you go through periods of volatility like this, the worst thing that you can do is disinvest. Stock markets have a tendency to move quickly on the downside, but it is important to remember that some of the better days of market performance come after such a fall. Therefore, we have not been tempted to sell any equity exposure when we could be close to a market low, and markets could likely bounce from these levels. In fact, we have been investing any surplus cash into the market, because we have seen a number of opportunities present themselves in the recent sell-off. Good quality companies and investment trusts that have suffered profit taking have seen their share prices come back to levels where we feel it is now an attractive entry point.
To conclude, we are conscious this has been a more volatile start to the year. Investment markets often go through periods like this. Whilst short term volatility can feel uncomfortable, we remain long term investors and look to take advantage of opportunities that present themselves in environments like this.
If you have questions please get in touch on 0161 518 3500 or email a member of the team.
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