By Sonja Laud, Legal & General Investment Management

Even though we’re only a few weeks into the new year, investors have already seen some significant moves in markets. In a special CIO call, we discussed how they might play out.

Last week I sat down with Colin Reedie, Head of Active Strategies, and Tim Drayson, Head of Economics, for a live webinar with clients to assess the investment outlook for 2022 in light of recent market and macro developments.

You can listen to an audio version via LGIM’s podcast channel on Apple, Spotify, our website and Audioboom, where the first instalment of our two-part outlook series is also available. During the call, we made the following key points.

Accelerating change

Society could be on the cusp of another ‘Roaring Twenties’, amid the global economic recovery and rapid technological change. That’s because each successive wave of COVID-19 appears to have a lower impact on economic growth, while the pandemic – which has fundamentally altered how we live, work and play – has accelerated key themes of which investors need to be aware.

We will, of course, continue to research and engage on the associated environmental, social and governance issues. This year, among other topics, our Global Research and Engagement Groups will focus on climate change, as well as inequality, cybersecurity, health and obesity.

Hear from Sonja, Tim Drayson and Colin Reedie

Inflation implications

While inflation is likely to ebb from current levels, it’s unclear whether and when it will return to target. It could remain stubbornly high, in economies at full capacity, triggering further upward pressure on wages.

Markets appear to be underestimating either how high interest rates need to go, or how stubborn inflation will be. This means 10-year US Treasury yields could rise materially, in our view.

Growing volatility

We expect greater market volatility this year, as central banks balance the risk of tightening policy too far, too fast versus the danger of being behind the curve on inflation. Indeed, a hawkish pivot is already underway at the US Federal Reserve, while we believe the Bank of England may raise rates again in February.

Disclaimer: Views in this blog do not promote, and are not directly connected to any Legal & General Investment Management (LGIM) product or service. Views are from a range of LGIM investment professionals and do not necessarily reflect the views of LGIM. For investment professionals only.

Will McIntosh-Whyte, manager of Rathbones’ range of four risk-rated sustainable multi-asset funds, answers questions about why sustainable investing makes sense, what he hopes to achieve with this range and what some of the challenges and opportunities are in managing sustainable multi-asset portfolios.

1. Why is sustainable investing gaining traction?

There’s no denying that demand for sustainable investing has risen sharply. This has been driven in large part by people wanting to not only reflect their values in their investments, but also make a positive impact with them. The trend has been given extra impetus from regulatory changes requiring advisers and investment managers to add environmental, social and governance (ESG) considerations to their suitability checks. So yes, sustainable investing is on the rise, but how you go about it is crucial – how do you know if your approach is truly sustainable, for the planet and for investment returns?

2. How can you cut through the noise and green-signalling to identify what is truly sustainable?

Though it’s rarely acknowledged, there is lot of grey area, nuance and subjectivity involved in analysing companies for their sustainability credentials. It requires an active, common-sense approach by those who have experience and expertise in the area. For this reason, our day-to-day management of the Rathbone Greenbank Multi-Asset Portfolios (RGMAPs) is supported by Rathbone Greenbank Investments (Greenbank), who have been pioneers in the development of sustainable investing since 1997. Their ethical, sustainable and impact (ESI) research team use their proprietary database of profiles on companies, governments, and other entities to independently scrutinise every asset in our funds against our pre-determined and clear sustainability criteria. The Greenbank team analyses the specific merits of each entity’s activities in detail and how it addresses sustainability and responsible business issues, as well as the quality of its response. This ensures our funds only invest in ways that are truly aligned with the UN’s Sustainable Development Goals (SDGs), an agenda for global sustainable development adopted in 2015 by all UN member states.

Just to give one example of the complexities involved, take the full lifecycle of an electric vehicle. When you delve into it, you start to uncover some difficulties from a sustainability perspective, such as the cobalt mining that is necessary for making the batteries. Often, only relying on third-party ESG ratings and not doing your own in-depth analysis, can mean missing some of these crucial sustainability issues. This is one of several challenges that our stewardship team have been exploring in a series of articles for our quarterly InvestmentInsights publication.

3. What are the benefits & drawbacks of using third-party ESG data?

While we do use ESG data from external providers as part of our analysis, we do not rely on that alone. We find these external sources a useful starting point for our own research as it can be a quick way to identify red flags that would rule something out or highlight areas of operational strength or weakness to investigate further. We’re also able to take some of the raw data points such as health and safety stats, emissions, etc. and feed them into our own database. As with any external information source, it’s important to understand the methodology used in order to know what the data is and – more importantly – isn’t telling you. For example, some ESG ratings are relative to individual sectors and are highly dependent on what issues (e.g. data security, climate change, employee relations) that the data provider has determined to be most important for that sector. In some cases we find quite a good alignment between their views and ours, but often we’ll have quite a different view. There can also be a bias in external ratings towards companies that report more information. A company might get a poor score not because it’s worse than its peers, but because it just isn’t putting as much information into the public domain. So it’s important to do further digging.

Our in-house research into organisations draws on company reports, monitoring of news flow, company meetings, NGO reports and other third-party sources. These include specific benchmarks and data sources such as environmental impact tracker CDP’s scoring, Workforce Disclosure Initiative and Access to Medicine Index. Researching a company’s sustainability credentials involves a great deal of data analysis as well as qualitative research. We of course have an objective framework for rating companies from a sustainability point of view, but we think it’s crucial to always have a human sense check at the end.

4. Can you tell us more about your criteria, and how you define ‘sustainable’?

For us, sustainable means investing in companies and entities which are benefiting people and planet by working in ways or providing goods and services that support sustainable development. To do this in practice, all equities and corporate bonds within our portfolios must align to one of Greenbank’s eight sustainable development categories which map to the UN SDGs. These eight categories focus on crucial areas of sustainability such as energy and climate, health and wellbeing and resource efficiency. We also believe that some areas are simply inconsistent with sustainable development, which is why we screen them out of our portfolios. For us, oil and gas companies and miners don’t belong in sustainable funds.

We believe it is important to apply sustainability criteria to all asset classes. We use a customised criteria for more complex asset classes, for example government bonds and commodities, rather than simply excluding them fully or alternatively compromising on sustainable values.

Importantly, Greenbank can veto investments which do not meet our funds’ responsible investment policy, ensuring it’s applied without bias or influence from us, the fund managers. Equally the team, supported by Rathbones’ wider stewardship resource, continues to actively undertake stewardship activities such as voting, engagement and monitoring on behalf of our investors.

5. Can you achieve true diversity in a sustainable portfolio? Doesn’t the sustainability criteria limit your choices?

We believe it is not only possible, but necessary to create sustainable portfolios that are genuinely diversified. It’s simply not enough to just be ‘sustainable’. Everything in the portfolio has to either generate a return or hedge a risk, and you need to have the right balance of both. What we don’t want to be is just another questionably diversified ‘60-40’ fund with a sustainable badge thrown on it.

Given that all investments must support sustainable development, providing diversification while keeping true to your sustainability principles can be done, it just takes a little more work. For instance, government bonds are an important tool for multi-asset portfolios, and we believe they have a place within sustainable portfolios too given the significant positive impacts governments can have on the environment and society. But, for their bonds to be eligible for inclusion in our funds, countries must pass three out of four of our sustainable qualifying criteria related to military spending, corruption, civil liberties and climate change action. While bonds are available to help diversify our portfolios, the universe is reduced – for example, US Treasuries are currently ineligible for inclusion because of the American government’s inaction on climate change and heightened defence spending. But Japanese and UK government bonds have passed our criteria and are held right now. However, there are supranational bonds in many countries and currencies that can offer similar exposure to sovereigns, but in a more sustainable way. Another asset class with current limitations is commodities. They can be particularly valuable as a hedge against inflation. However, it is difficult to ensure they align to sustainable development due to their mining processes. So, to diversify and hedge risks that commodities and similar assets would provide, we can use other tools, such as foreign currencies and structured products, that balance our risks without compromising our values.

In order for our funds to be able to invest in commodities (apart from fossil fuels, which are excluded due to their damaging impact on the climate) we have created a set of sustainability criteria which they must meet. These include providing supply-chain transparency, with independent verification that there are no significant issues regarding labour rights, human rights or environmental degradation across the supply chain. Due to our strict criteria, commodity investments are excluded from our portfolios for now. However, we believe as we continue to transition to a more sustainable world over time there may be some commodities which meet the criteria, so we’re not ruling them out for future consideration.

6. How does risk management for sustainable multi-asset portfolios compare with managing risk for a traditional multi-asset portfolio?

In order to construct portfolios effectively and manage risk, we use our forward-looking Liquidity, Equity-type risk and Diversifiers (LED) framework, which is the same one we’ve been using for years in our other multi-asset portfolios. Because fixed income, equities and alternative investments can behave in different ways, even compared with similarly labelled investments, we want to make sure that assets are categorised by their liquidity and correlation to equities, particularly during periods of market stress. This helps protect our portfolios adequately and limit drawdowns.

For example, within the Equity-type risk bucket we include investment grade corporate bonds and high yield bonds, alongside equities. We do this because during a market downturn these bonds tend to correlate highly to equities and therefore are unlikely to provide much protection when you need it most. This must be considered carefully when constructing a portfolio.
We use several other tools to manage risk. These include assets within our Diversifiers bucket that can provide returns that are uncorrelated to equities, for example put options and structured products linked to interest-rate volatility or currency momentum. These assets aren’t considered Liquidity assets because they don’t have the same ease of buying and selling quickly in stressed markets compared with, say, developed market government bonds. We also have the ability to hedge our currency exposure, enabling us to choose the best companies globally and only take the currency exposures we want. For example, we can retain exposure to the yen, which tends to act as a safe haven during difficult markets, as a risk-management tool.

You can read more about the Rathbone Greenbank Multi-Asset Portfolio range; speak with your usual Rathbones representative; or contact the team on 020 7399 0399 or at rutm@rathbones.com

This is a financial promotion relating to a particular fund range. Any views and opinions are those of the investment managers, and coverage of any assets held must be taken in context of the constitution of the fund and in no way reflect an investment recommendation. Past performance should not be seen as an indication of future performance. The value of investments may go down as well as up and you may not get back your original investment.

It’s been difficult to catch up on the news lately without seeing headlines of inflation hitting 30-year highs. But are we heading back to the 1990s? What can be done? And does inflation even matter in financial planning, asks Steph Willcox, Head of Actuarial Implementation at Dynamic Planner?

What is inflation?

Inflation is the decline of purchasing power of a given currency over time. As is tradition when discussing inflation, this can be demonstrated by the price of Freddos. When I was small, I could buy 10 Freddos for £1. Now I can only buy four. Therefore, my purchasing power has been eroded by Freddoflation.

An estimate of inflation can be reflected in the increase of an average price of a basket of selected goods and services in an economy over a period of time.

The rise in the general level of prices, often expressed as a percentage, is the thing that we state as inflation.

It is of course important to remember that the price of goods can be affected by lots of things, all of which will be captured as ‘inflation’, but could be driven by currency fluctuations, supply issues, increases in business expenditure or any number of different reasons.

Equally, it’s important to recognise that different goods increase in price at different rates, and ‘inflation’, as it is calculated, is only an estimate of the average change in purchasing power.

Freddos have traditionally increased much quicker than inflation, so if your entire basket of goods was made up of Freddos, (please note, this is not a recommendation), your personally experienced inflation level would be much higher than the average inflation level quoted.

What is high inflation?

The Bank of England’s Monetary Policy Committee is responsible for maintaining a target inflation rate, currently set at 2%, although their expectations are that inflation will remain around 5% until April 2022 when it will peak at 6% before gradually returning to the targeted rate.

This level of high inflation is being influenced by emerging from the pandemic, rising consumer energy prices, disruption to supply chains and good shortages.

Of course, the inflation level can’t be allowed to drift forever and the MPC will take measures to reduce inflation through a change in monetary policy. It’s important to note that monetary policy cannot solve supply-side issues, but it can still be used to alter inflation levels in the medium term.

The Committee can choose to change policy in the form of an increase to interest rates, or a reduction in the current quantitative easing programme.

As interest rates rise, borrowing through loans and mortgages becomes more expensive and savings become more profitable. This shifts consumer habits away from spending, reducing demand, and therefore reducing inflation. We’ve already seen one increase in interest rates, making England the first developed nation to increase interest rates following the global pandemic, and more rate rises are expected.

Quantitative easing, which was first introduced in 2009, is where the Bank of England buys back bonds from the private sector, financed by the creation of central bank reserves.

The aim is to increase the price of bonds, by stimulating demand, which will reduce bond yields. As bond yields reduce, so does the interest rates on savings and loans. Therefore, stopping quantitative easing would be expected to reduce the demand of bonds, reducing the price, and increasing the yields. Increasing bond yields will increase interest rates on savings and loans, and thereby lower inflation.

Changes in monetary policies can take up to two years to see their effects fully felt within the economy, so any change in policy will not be a quick fix.

Should I be worried about inflation in financial planning?

With inflation playing such a major role in an individual’s purchasing power, it’s of course vitally important that this is reflected in the advice process, and it is even more necessary when creating a long-term cash flow plan for your clients.

As we see, inflation is not a static number and therefore shouldn’t be modelled as such.

Dynamic Planner forecasts real returns – therefore net of inflation – across its system, in the risk-reward trade-off shown for risk profiling, in investment portfolio reviews and in cash flow planning.

The forecast is generated by a Monte Carlo scenario engine that generates thousands of possible real returns over 49 asset classes. As the returns are real to begin with, the various possibilities for inflation at different times are already factored in. It is therefore inappropriate to guess and factor in other numbers for inflation and apply them to the forecast.

As both the returns and the forecasts are real, you don’t need to worry about inflation – it’s already all accounted for. You can be confident that you are seeing the expected purchasing power of a client’s assets at each point in time, even through these times of increased volatility.

Further to this, the Asset Risk Model and the Dynamic Planner risk profile asset allocations are stress tested to ensure that you can have confidence in our growth assumptions and plan confidently with your client. The stress testing performed in late 2020 focussed purely on inflation and the emergence from the global pandemic.

So, perhaps now is the time to reassure your clients that inflation fluctuations are expected and covered in our modelling, and that their retirement plans will remain on track – as long as they’re planning on purchasing something that isn’t a Freddo.

Read more about Dynamic Planner Cash Flow

by Guy Monson, CIO and Senior Partner, Sarasin & Partners LLP

2021 was a year of unexpectedly strong recoveries. The IMF, for example, in its October 2020 outlook, pencilled in US GDP growth of 3.1% for 2021 – by last quarter that had almost doubled to a red hot 6% (with similar upgrades across much of the developed world). Corporate profits were similarly exceptional, with US earnings for the S&P500 rising 40% from their levels of just a year ago. Perhaps most intriguing was the level of global mergers and acquisitions where, despite virus restrictions and lockdowns, the value of deals agreed in 2021 climbed to the highest levels since records began more than four decades ago . Set against these near bubble conditions, it is not surprising that global equity markets posted a third year of double digit returns and that bond yields rose. Higher inflation was of course the price we paid (UK inflation started the year at 0.7% and ended at 5.1%), but this did not stop 2021 from being another vintage year for equity investors.

After a strong 2020 for us at Sarasin, we found last year more challenging. Yes, we remained overweight equities and underweight bonds (with little net exposure), but we were much more cautious in our stock selection. In particular, we were underweight (relative to the index) the narrow group of US mega-cap companies, mainly technology and consumer names, that led markets higher for much of 2021. We held instead to our long-term thematic positions geared to climate change, automation and ageing. We were by no means absent the digital winners (indeed digitalisation is also one of our themes), we just didn’t hold enough, particularly of the biggest (Apple) or the most fashionable (Tesla). The effect is well illustrated in Chart 1, which shows the performance of the traditional world equity index (weighted by market capitalisation), compared to an equally weighted index where each stock is accorded the same holding size. The underperformance of the latter since the spring of last year is clear and reflects the broad challenges we faced, despite many of our companies posting exceptionally strong growth of both earnings and dividends. So yes, we made good absolute returns for clients, but relative to the index, our performance looks conservative.

So, do we now stick to our cautious equity approach or, do we join the party, and sharply increase our global mega-cap positions? There are arguments for the latter – certainly the largest US companies have consistently delivered superior organic growth, pricing power and prodigious cash flow, all well in excess of the wider index. While this has rightly been rewarded by shareholders, it has now led to some of the most extreme stock-price dispersion and equity concentration in stock market history. Against this backdrop there are three specific issues that concern us:

1. We have hardly started to taper, yet

Last month still saw the world’s central banks buying bonds (QE), at close to record rates – that isn’t exactly tapering, or at least not yet. Things will change though in 2022; the accelerated wind-down of the Federal Reserve’s purchases (QE) will begin in January, while the ECB’s giant pandemic emergency purchase programme (PEPP) ceases in March 2022 (it will be replaced, but with a smaller programme). The Bank of England’s programme has now ended, as have purchases by the Central Bank of Canada. In other words, open-ended QE by western central banks, first deployed in 2009, may soon be history. This, in turn, opens the door to not only interest rate rises (three increases in 2022 and 2023 in the US) but also Quantitative Tightening as Central Banks allow their balance sheets to shrink by letting maturing bonds run off.

This fundamental shift in monetary policy will have huge implications for markets – we should expect volatility to rise, bond yields to trend higher and more speculative investments (some crypto-currencies, for example) to struggle. Equity market leadership will also evolve – in particular, as the inflows of money into the system are reduced, the flows into the mega-cap companies may be impacted, simply because of their sheer size. Highly valued equities also tend to underperform in a rising rate environment, as the discount rate applied to future profits rises. None of this will occur overnight but the direction of travel seems clear.

2. The market impact of Omicron is different this time around

It is now generally accepted that Omicron is more infectious than previous variants but also intrinsically milder. Yes, that means that Omicron will spread much faster and further than earlier waves, but will likely peak much faster too (one South African epidemiologist described it as more of a “flash flood” than a wave). Importantly for those hospitalised, the average hospital stay is up to 50% shorter and fewer need ventilation/ICU support (which is critical given the extreme capacity constraints that remain within hospitals).

This different pattern of infection has implications for global markets. In previous COVID waves, severe lockdowns led to weaker economic growth, but also to lower bond yields and massive central bank support. The result, on balance, was that despite the damage sustained by the real economy, asset prices tended to rise. In particular, generous liquidity conditions, coupled with work-from-home policies, tended to favour the US digital winners and associated global mega-caps. Today, the situation is different; Omicron has thankfully not triggered full scale lockdowns (Asia excepted) but it has meant that central bankers are freer to continue tightening policy, in the face of inflation rates that are far higher than in earlier phases of the crisis. In a worst-case scenario Omicron actually adds to these pressures (through tighter labour markets and supply disruptions).

Such a fundamental shift in the policy response to the virus naturally has implications for market leadership. It suggests that tomorrow’s winners may include more companies that benefit from tighter money (financials), from massive climate spending (industrials) and also those that offer meaningful alternatives to bonds (global income stocks). This is a big transition and again, will not occur overnight, but it is another argument that the leadership we saw last year is not for ever.

3. China – Signs of policy reversal?

2021 was a year where China’s tilt away from the West intensified, including greater assertiveness towards Taiwan, a tighter security regime in Hong Kong and restrictive economic policies targeted at countries such as Lithuania, Canada and Australia. Domestic policy was also challenging; regulators were antagonistic toward internet companies and education providers, while credit and leverage restrictions amplified already severe problems in the property sector. Taken together these policies contributed to a particularly sharp underperformance of Chinese equities, with the MSCI China index lagging the US S&P500 equivalent by an extraordinary 50% last year.

More recently though there have been tentative signs of a policy reversal. The Chinese central bank (PBOC) has now loosened monetary conditions through a reduction in banks’ reserve requirements while vowing, along with all government departments, to take “proactive” moves to ensure “economic stability” – we read this as short-hand for a limited bail-out of the property sector, more loosening of monetary policy and less heavy-handed regulatory intervention. In short it is a policy mix that argues for better returns for China-centric markets in 2022 and potentially for their embattled technology sectors. It is also a reason to suspect that the sharp underperformance of many Asian markets may be reversed – potentially attracting flows that had been destined for the US mega-caps and Nasdaq.

And if inflation rates prove sticky?

All of the above still makes one assumption – namely that global inflation rates fall back only modestly above central bank targets, by 2023. This is still our belief, and certainly a number of factors will combine to push downwards on prices next year. Used-car and gasoline prices rose by more than 50% in 2021 and that’s unlikely to happen again, while bottlenecks in global trade have started to loosen up. If we are wrong though, and risks are clearly to the upside, then there is the real possibility of bond yields climbing sharply or interest rates being tightened more aggressively. Both, in our view, could threaten the high valuations of the US technology and consumer sectors – and the correction could be sudden and aggressive. This is not our base case, but the risks need to be monitored.

In summary, our policy is to remain overweight equities, but to be cautious in our equity selection. Long-term thematic credentials, robust progress on ESG issues and, where possible, sustainable dividend support are the characteristics we are prioritising. When it comes to equity selection in 2022, fortune, we feel, may well favour the cautious.

IMPORTANT INFORMATION

If you are a private investor, you should not act or rely on this document but should contact your professional adviser.

This document has been approved by Sarasin & Partners LLP of Juxon House, 100 St Paul’s Churchyard, London, EC4M 8BU, a limited liability partnership registered in England & Wales with registered number OC329859 which is authorised and regulated by the Financial Conduct Authority with firm reference number 475111.

It has been prepared solely for information purposes and is not a solicitation, or an offer to buy or sell any security. The information on which the document is based has been obtained from sources that we believe to be reliable, and in good faith, but we have not independently verified such information and no representation or warranty, express or implied, is made as to their accuracy. All expressions of opinion are subject to change without notice.</span

Please note that the prices of shares and the income from them can fall as well as rise and you may not get back the amount originally invested. This can be as a result of market movements and also of variations in the exchange rates between currencies. Past performance is not a guide to future returns and may not be repeated.

Neither Sarasin & Partners LLP nor any other member of the Bank J. Safra Sarasin group accepts any liability or responsibility whatsoever for any consequential loss of any kind arising out of the use of this document or any part of its contents. The use of this document should not be regarded as a substitute for the exercise by the recipient of his or her own judgment. Sarasin & Partners LLP and/or any person connected with it may act upon or make use of the material referred to herein and/or any of the information upon which it is based, prior to publication of this document. If you are a private investor you should not rely on this document but should contact your professional adviser.

Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect of any such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct. indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.

© 2022 Sarasin & Partners LLP – all rights reserved. This document can only be distributed or reproduced with permission from Sarasin & Partners LLP. Please contact marketing@sarasin.co.uk.

By Jim Leaviss, Fund Manager at M&G Investments

After a tumultuous year for fixed income markets, fund manager Jim Leaviss presents his outlook for 2022. Jim considers the outlook for inflation and what this means for central bank policy and financial markets. He also looks at some of the more recent macro developments, such as the emergence of the Omicron variant, a hawkish pivot from the Federal Reserve and a rate hike from the Bank of England.

The value and income from a fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. Where any performance is mentioned, please note that past performance is not a guide to future performance.

Inflation – The dominant theme in 2021

If I had been asked at the beginning of the year where yields would be if US inflation were to hit 6.8% ‒ the highest since 1982 ‒ I wouldn’t have believed that 10-year Treasuries would be yielding just 1.4%. In the UK, the Retail Prices Index (RPI) reached 7.1%, yet 10-year gilt yields remain stuck at around 0.8%. Real yields are therefore in deeply negative territory.

It’s a similar story in the US Treasury Inflation Protected Securities (TIPS) market, with inflation breakevens having seen only modest rises this year. While 5-year US breakevens did climb to around 3.2% earlier in the year on the back of rising oil prices, they have since eased back to around 2.7%, which compares with around 2% at the start of the year.

Looking at the 5y5y breakeven rates (which shows us what inflation breakevens are expected to be 5 years from now, thus removing all of the COVID noise), we can see these are only modestly higher over the year, from 2% in January to around 2.5% now (see Figure 1). All of this clearly suggests that the market thinks inflation will be transitory.

Figure 1. 5y5y inflation swap: market’s expectation of 5-year inflation, in 5 years

US 5y5y inflation swap

Source: Bloomberg, 18 December 2021.
Past performance is not a guide to future performance

To a certain extent, this downward trajectory in inflation is baked in, with inflation likely to moderate from its current high levels. For instance, unless we see another doubling in oil prices, base effects will start to fall out of the equation over the next few months. Meanwhile, new manufacturing capacity coming on line should help reduce product costs – after all, semiconductors cannot be stuck on ships forever – and this will help bring down the prices of things such as new cars.

Wages are a key driver of inflation over the longer term, but, so far, we see little evidence of a 1970s-style wage price spiral. While increases in the US minimum wage could have some impact, union representation remains very low, and the rise of the gig economy is likely to continue to suppress wages.

Inflation is also likely to be an increasingly dominant issue from a political perspective. Indeed, in the 1980s inflation was the number one election issue, and I can see inflation becoming a hot topic once again as we approach the mid-term elections in 2022.

Central bank watch

US Federal Reserve (Fed): the December meeting saw a hawkish pivot from the Fed, with inflation very much the dominant theme. The Fed ‘dot plots’ now indicate three 0.25% rate hikes in 2022, followed by another three in 2023 and another two in 2024. This equates to a 2% tightening over the next three years, which was slightly more than anticipated.

The Fed also increased the tapering of its bond purchases by $30bn, with tapering set to end altogether by March 2022. So far, the bond market reaction has been very muted and certainly nothing to compare with the sell-off we saw during the ‘taper tantrum’ of 2013.

From a valuation perspective, we think US Treasuries currently look about fairly priced, with forward-looking yields now broadly in line with the Fed’s long-term expectations for rates (see Figure 2).

Figure 2. 10-year US Treasuries 10-year forward

Forward-looking yields versus the Fed’s long-term expectations

Source: Bloomberg, Federal Reserve, 17 December 2021.
Past performance is not a guide to future performance

European Central Bank (ECB): we also see a slightly more hawkish response at the latest meeting, with the ECB announcing a cut in its bond buying under its Pandemic Emergency Purchase Programme (PEPP). That said, the ECB has left itself some flexibility to adjust this programme if the outlook deteriorates. It is worth noting that the inflationary backdrop in the eurozone is very different from the US and the UK, with the region seeing much lower levels of inflation so far.

Bank of England (BoE): the bank recently hiked rates to 0.25% in response to the recent high CPI reading. However, this seems to overlook the fact that the UK is in the process of closing down its economy, while recent GDP figures suggested the UK economy was already slowing. Some commentators have suggested a possible policy error here, and it is unclear why the BoE has not waited until the impact of the Omicron variant was a bit clearer before making this decision.

Omicron – Economic impact could be underestimated

The emergence of the new Omicron variant of COVID-19 sent jitters through financial markets in the final weeks of 2021, leading to a sell-off in parts of the credit market. The new strain appears highly virulent, with hospitalisations almost certain to increase due to the sheer number of new cases. However, compared to this time last year there are grounds for some optimism given the high level of vaccinations and new treatments.

That said, we could be at risk of underestimating the economic damage the new variant will cause, especially in light of recent soft economic data in the UK. GDP is still well below its pre-COVID trend, and this could be exacerbated by wages failing to keep pace with inflation.

It is a similar story in the US, where we have seen a recent downturn in consumer confidence and weak retail sales. These are traditionally reliable lead indicators, and we shouldn’t completely dismiss the risk of a recession in 2022. A flattening yield curve is another bearish signal which needs to be considered.

What happens after a rate hike cycle begins?

Research from Deutsche Bank takes a look at what has previously happened in the years following the start of a new rate hiking cycle. The research suggests that it generally takes three years after the first hike for a recession to hit. In the meantime, government bond yields tend to rise on average by 111 bps in the first year following a hike, before falling back over the following two years (see Figure 3).

Figure 3. The year after the Fed hikes

Average BBB credit spreads performance in Fed tightening cycles since 1955 by month

Source: Deutsche Bank Research (Jim Reid et al.), GFC, Haver Analytics – “When the Fed hikes”, December 2021. Grey shaded area represents range of outcomes in hiking cycles analysed.
Past performance is not a guide to future performance

Meanwhile, equities rally by an average 7.7% in the 250 days after the first hike, before giving back these gains over the rest of the year. Credit usually follows the path of equities, with spreads initially tightening, before widening back to their starting point in three years’ time. Of course, it should be highlighted that the starting point for credit is already very tight, so spreads perhaps may not see the initial 49bps tightening they have seen historically.

Can central banks really influence inflation?

There is much debate as to whether rate hikes can really dampen inflationary pressures. Higher rates will clearly have no direct impact on oil prices or supply-chain bottlenecks, the two big drivers of inflation this year. The majority of mortgages are now fixed – both in the US and the UK – so there will be no immediate impact through that mechanism.

Central banks took a lot of the credit for the fall in inflation since the 1980s, but in reality this was largely driven by other factors, such as globalisation and technology. The fact is, it is not clear how far rates really influence inflation, and how much central banks will really be able to do if inflation does get out of control.

Credit – A world of rising stars

We are currently in a world of ‘rising stars’, as opposed to the ‘fallen angels’ backdrop of 2020. We are currently seeing around $20bn a month of companies being upgraded from junk to investment grade, and the Bank of America expects to see a further $70bn worth of upgrades next year.

Another key trend in 2021 has been the return of dispersion. The months following the pandemic saw indiscriminate tightening across credit, but we are now seeing more diffusion between individual credits and sectors. This is especially apparent in the high yield space, where we are seeing the clear emergence of good credits and bad credits.

Looking at fundamentals, leverage has come down a bit in 2021 from last year. However, this is off a very high base, and debt relative to earnings is still twice as high as it was in 2010. Defaults remain very low, with default rates of less than 1% in the high yield space. From a regional perspective, US credit continues to offer a meaningful spread pick-up versus other regions, even after currency hedging costs are factored in.

Environmental, social and governance (ESG) continues to be a growing and important trend in global bond markets. In 2022, we expect to see further significant issuance in the ESG bond space, particularly sustainability-linked bonds and green bonds. While Europe has traditionally led the way in the sustainable investment area, we are also seeing increasing interest in the US.

As we look ahead to the new year, we would also highlight the so-called ‘January effect’. Typically, technical drivers have often led to outperformance for credit at the beginning of the year. This could be due to a variety of factors, such as macro investors being short credit relative to equities, and looking to rebalance their portfolios at the start of the year.

Emerging markets and currencies

It was a challenging year for emerging markets in 2021, dominated by themes such as the Evergrande debt crisis in China, COVID worries amid low vaccination rates, and rising inflation. Turkey was the big story as the lira collapsed by more than 50%.

Many EM local currencies got hammered, including many with reasonably solid fundamentals, such as the Mexican peso, which as an oil producer should have benefited from the recent rise in energy prices. If one is prepared to accept volatility, we do think EM contain many areas that offer attractive positive real yield.

It was also the year of the US dollar which was up against almost everything. This anticipated the likelihood of future Fed rate hikes, although dollar bullishness is starting to appear something of a consensus and the currency does appear expensive on some valuation metrics, such as Real Effective Exchange Rates (REER).

Looking at the OECD’s Purchasing Power Parity (PPP) measure, the euro is around 26% undervalued, while the Japanese yen, sterling and Mexican peso also appear somewhat cheap. As per the norm, the Swiss franc looks expensive, along with the Norwegian krone and Australian dollar (see Figure 4).

Figure 4. Currency valuations globally

Trade based valuations

Source: Bloomberg, 17 December 2021.
Currency valuation models key: DBeer = behavioural equilibrium exchange rate (Deutsche Bank); FEER = fundamental equilibrium exchange rate; PPP = purchase price parity

Another currency that looks strong is the Chinese renminbi. Potential intervention from the People’s Bank of China (PBOC) to weaken the currency could be something to watch out for in 2022.

An extraordinary time for bond investors

We are living through extraordinary times in bond markets. Despite US inflation heading above 6%, 30-year bond yields remain below 2%, while credit spreads remain near all-time tights. At face value, fixed income valuations don’t look very compelling, although we do think that pockets of value can be found.

In terms of fixed income assets that might do well in an inflationary, rising rate environment, we continue to see attractions in inflation-linked bonds, such as US TIPS. Another area which I think could do well is emerging market bonds. In contrast to the negative real yields in traditional developed markets bonds, emerging market bonds can provide positive real yields of around 2-3%. There’s going to be a lot of risk and volatility as always when investing in emerging market bonds, but in terms of valuation that probably looks the best place to be in fixed income at the moment.

2022 is likely to be the year when we find out whether inflation proves to be transitory or looks to become more permanent, and this is likely to be a key driver for fixed income markets. It will also be fascinating to see whether the high valuations across risk assets – such as equities and high yield bonds – can be sustained as the huge levels of monetary stimulus start to be reined in.

M&G
December 2021

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by Alex Funk, Chief Investment Officer, Schroder Investment Solutions

Climate change impacts potential future asset class returns in in three main ways:

• The first concerns physical costs, taking into account the risks to physical assets and infrastructure from rising temperatures and changing weather patterns.
• The second concerns transition costs, taking into account the high level of investment required from governments and businesses to align with more sustainable, carbon neutral outcomes to reduce climate change.
• The third concerns stranded assets, taking into account the impact on economic growth and on individual businesses of leaving fossil fuels in the ground in order to limit climate change.

Together these have an impact on inflation and the factors that help drive asset returns, in particular productivity, which collectively feed through to determine GDP growth.

From a portfolio construction perspective, what is interesting is how governments and businesses respond to rising temperatures. Here it is worth noting that while a warming earth is bad news from an environmental perspective and no-one stands to benefit from higher temperatures on a longer-term horizon, they are not universally bad for growth. The economies of countries in yellow, green and blue in the chart below should be less severely affected by increased temperatures than those shown in red, for example.

Higher temperatures are not always bad for growth

Source: Burke and Tanutama (2019).

The reason for this relate to productivity, which is one of the most important drivers of asset class returns. The chart above shows the impact of climate change on the productivity of economies of cooler and warmer countries and regions in two scenarios; the first where no climate action is taken and the second where some action is taken to partially mitigate climate change.

Impact of climate change on productivity % p.a. 2021-2050*

Source: Burke and Tanutama, Cambridge Econometrics, Schroders Economics Group. January 2021.

The chart above shows the impact of higher temperatures measured as the difference in productivity of the partial mitigation and No Action scenarios relative to the No climate change scenario, in which there are no transition and physical costs.

In the ‘no action’ scenario you can see that the productivity of cooler countries actually increases because as temperatures start to rise, productivity can improve in areas such as manufacturing, which can be curtailed when temperatures are low. In warmer countries however, as temperatures rise and conditions become more humid, productivity in some sectors can decline. ‘Partial mitigation’ decreases the productivity benefits in cooler countries but also decreases the negative impact in warmer countries.

Further factors that need to be considered include the likely introduction of carbon taxes by governments. Carbon taxes involve taxing industries that are emitting high levels of carbon into the atmosphere, such as oil and gas, more aggressively. Carbon taxes will push up the price of the products of high carbon emitters to the end consumer, which should curtail demand and lead people to seek out alternatives. Money raised through carbon taxes will provide governments with funds to invest in alternative energy sources and improved energy infrastructure which should help to speed up the move to a greener economy.

The cost to businesses and economies of aligning to the targets set out in the Paris Climate Agreement should also be taken into account. Then there is the affect on productivity in different sectors and industries to consider as we move away from traditional fossil fuel consumption towards cleaner energy.

Stranded assets are another key issue.

The chart below shows the carbon emissions in reserve of listed companies in major economies around the world.

Carbon emissions in reserves in billion tonnes of carbon of listed companies

Source: MSCI, Refinitiv Datastream, Schroders. January 2021.

As we move towards a carbon neutral or a net zero world, this is effectively the amount of coal, oil and gas that will have to be left in the ground. You would expect this to have the biggest negative impact on export heavy emerging economies that are currently most dependent on oil and gas and mining to drive growth. The chart below shows the reduction in equity returns that we could see across major economies from stranded assets, with the biggest hit seen in emerging markets.

Reduction in equity returns from stranded assets in a partial mitigation scenario (% p.a. 2021-50)

Source: Refinitiv Datastream, Fossil Free Indexes, Schroders Economics Group. January 2021. We use the Nifty Index for India and the Shanghai Stock Exchange Composite Index for China since we have data for companies listed on their domestic stock exchange.

To construct portfolios that account for the impact of climate change all of these factors must be considered. Clearly there is still a large amount of uncertainty relating to the decarbonisation of the global economy when forecasting long-term returns from asset classes, but as we progress towards a greener economy more information is constantly becoming available, helping us to refine our understanding of these issues further.

For more information on the Schroder Sustainable Model Portfolios and Schroder Investment Solutions, simply visit www.schroders.com/investment-solutions, contact your usual Schroders’ representative or call our Business Development Desk on 0207 658 3894.

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by Ruffer LLP

Financial conditions have never been so accommodative

Source: Ruffer LLP, Bloomberg

Omicron or not, the US economy is booming. The cocktail of pent-up animal spirits, household net worth at all-time highs plus hefty measures of monetary and fiscal stimulus is a potent one!

The Atlanta Federal Reserve ‘NowCast’ has US Q4 real GDP at 7%; add 6% CPI inflation and you get a 13% nominal growth rate . The growth picture is similar in Europe and the UK. One would have to go back 50 years to find a similar surge.

The fly in the ointment is inflation– from energy and housing to wages, raw materials, and food. In a nutshell, too much money is chasing too few goods.
With this backdrop, does the US really need the easiest financial conditions on record? As former Federal Reserve Chair McChesney Martin once said: “the job of the Fed is to take away the punch bowl just as the party is warming up”.

It’s time to poop the party

This month’s chart shows the Goldman Sachs Financial Conditions Index, a composite including interest rates, equity valuations, borrowing costs and currency data to assess how ‘easy’ or ‘tight’ financial conditions are. This offers a broader gauge than the blunt tool of interest rates. The message is clear: the current concoction is almost all vodka, with just a dash of fruit juice.

This matters because asset prices have been driven higher on a sea of abundant liquidity and stimulus. For the first time in at least a decade, central bankers are beginning to acknowledge they are behind the curve. The political pressure to ‘do something’ is rising.

In 2022, it seems likely interest rates and bond yields will rise, quantitative easing will melt away and there will be less of a fiscal stimulus impulse.

We must be clear on the broader context here: policy makers are still extraordinarily supportive of the economy. In reality, tapering amounts to less easing rather than meaningful tightening; interest rates will remain negative in real terms and near multi-century lows. But prices are set at the margin – markets respond as much to flows as they do to the stock – and financial conditions will tighten.

In a highly financialised world policymakers face a conundrum: to tame inflation and moderate growth they must reverse the very conditions that have been so beneficial for stock markets. We are bullish on economic prospects coming into the new year. But the irony is that the stronger the economy, the more vulnerable capital markets look. What the real economy needs, financial markets can’t handle.

So how to position portfolios? Avoid the obvious beneficiaries of easy money and liquidity – profitless ‘unicorn’ technology and the Jenga tower of corporate debt. Seek out assets which benefit from strong economic activity and recovery – energy stocks for example. Own the beneficiaries of those rising interest rates: UK and European banks alongside interest rate options which hedge your portfolio duration. This is how we are positioned.

One notion of successful investing is to have the world come to agree with you… but later. What excites us is the valuation gulf between these assets suggests most market participants don’t agree with us.

Duncan MacInnes
Investment Director

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Dynamic Planner CEO Ben Goss believes advisers who focus on customer needs and see change as an opportunity, to demonstrate value in a hybrid world, are well placed for success in 2022. Below are the key themes Ben expects to see dominate over the next 12 months:

1. Hybrid models become an opportunity for differentiation – Hybrid approaches developed during the pandemic have become firmly established. The challenge now is for firms to enhance the virtual client experience, looking for ways to differentiate themselves through branding and online customer engagement.
2. Sustainability is not optional – If sustainability received a nudge into the spotlight from the pandemic in 2020, the past year has put it firmly centre stage. It’s looking increasingly certain that regulation will underpin the shift in the next 12-18 months by mandating sustainability as a part of suitability. Adviser education will be vital, as will simple tools and processes that enable firms to implement sustainability preferences in a consistent and repeatable way.
3. Consolidators look for efficiencies – The number of advice firms in the marketplace continues to fall – by 2% over the last 12 months, according to the FCA. We expect some of the consolidators to want to unlock efficiencies by centralising businesses around simpler propositions and shared customer experiences to drive productivity.
4. Regulation is laser-focused on suitability – From Consumer Duty to PROD, the regulator is looking hard at customer needs and how to meet them. The drive towards ‘risk-based journeys’ and the long-talked about Investment Pathways have the potential to create more activity in the direct to consumer space, presenting an opportunity to differentiate the value of personal, professional financial advice. PROD rules offer firms the ability to make their businesses more streamlined and efficient by focusing on target markets.
5. Inflation is back on the agenda – The outlook for inflation and interest rates is more uncertain than it has been in over a decade, while the road out of the pandemic is proving bumpy. These conditions mean it will be important for clients to be invested and to be diversified – and for advisers to use a risk-based cashflow planning approach that is equipped to model uncertainty.

Ben Goss, CEO at Dynamic Planner: “From hybrid working to sustainability, the pandemic has accelerated changes in our industry that might otherwise have taken a generation. There are two ways to respond: to resist change or to embrace it. Advisers who focus on the needs of their customers, make use of the technology and tools at their disposal, and see change as an opportunity to demonstrate their value are well positioned to thrive in 2022 and beyond.”

Don’t miss Ben Goss’ Keynote at our 2022 Conference.

By Head of Product, Josh Knight

Over the past few months, we have added a number of new features and enhancements in Dynamic Planner.

An important, overarching aim, threading them together, is providing a smoother user journey and consolidating and re-organising lots of supporting functionality that drives your productivity in Dynamic Planner.

1.1 Document store

First, we have added a central place to see all documents that you have saved for a client. When you download a report, you can optionally save it to the client record. You can see all such saved documents in the new document list. You can also drag and drop to upload other documents to store alongside reports.

1.2 Relationship management

Alongside documents, you can now manage client relationships here too. In Dynamic Planner, each individual you give advice to is listed as an individual client. Clients are joined by Relationships, essentially creating a ‘Client’ and a ‘Partner’ for a specific piece of advice. The new functionality allows you to manage these relationships.

1.3 Intelliflo Office integration

Dynamic Planner’s integration with Intelliflo Office has received an update, allowing you to land in the latest version of Dynamic Planner, saving you a click or two in the process. When you click through into Dynamic Planner, you will be taken straight to the client for which you initiated the integration, allowing you to immediately start or continue a planning process.

1.4 Are you sure?

The final change you may have noticed, and by popular demand, is that we have implemented a sanity check when you try and move away from something you have been working on without saving.

We hope you find the enhancements useful. As always, your feedback as our clients and Dynamic Planner users is vital to helping us continue to improve the system for you. Alongside the above enhancements, I can say the team here have been busy working on some big, upcoming enhancements, but more on those over the coming weeks and months.
Please leave any feedback you have, however small, in Dynamic Planner’s feedback portal. We do read it all! Thank you.

Remember, you can join a member of our Client Success team for a monthly webinar, wrapping up latest enhancements in Dynamic Planner. With the exception of the next one in January, they are always on the second Wednesday [10am] of each month for 30min. Register your places for Q1 2022.

Advisers using Dynamic Planner’s Risk Managed Decumulation Service (RMD) can now access the Garraway Decumulation Model Portfolio Service.

The portfolio is the first decumulation portfolio built specifically to meet Dynamic Planner’s RMD Standard. It has been created using Dynamic Planner’s leading risk-rated portfolio guidelines and assigned a risk rating of 5.

Chris Jones, Proposition Director, Dynamic Planner said: “We welcome Garraway to our Risk Managed Decumulation service, with their specialist capabilities in hedge and managed futures. Advisers and their clients will benefit hugely from being able to access the expertise and scale of an institutional manager via Dynamic Planner.

“Back in April 2020, we effectively launched our RMD service into the pandemic – a timely coincidence with the events of the past 18 months continuing to bring this area of advice to the fore. The system has prepared clients for shocks and falls in capital value such as this, and to date the model and Risk Profiled funds have performed within the parameters an investor was led to expect.”

Mark Harris, Garraway DFM’s CIO said: “Dynamic Planner is the market leading risk-based system in the planning and advice process. With our aim to create a decumulation portfolio that is truly fit for purpose for the whole advisory market, it made perfect sense to work with the Dynamic Planner team to build the portfolio from scratch rather than trying to use an existing solution designed to meet the needs of a different target market

“The result is a portfolio that uses uncorrelated funds, rather than complex derivatives, to better match retirement duration whilst achieving the joint requirements of capital preservation and minimising drawdown. Putting it another way, our back testing shows that an investor could have made fixed withdrawals totalling over £49,000 per annum from a £1 million in this portfolio over 5 years and still have £1 million left. Of course, past performance is not a reliable indicator of future performance.”

The Key Features of Dynamic Planner’s RMD Service:

1. Focuses on monthly over annual risk.
2. Allows fair comparison of fund performance and charges for decumulation solutions, by filtering on only suitable solutions first it avoids the temptation to use other solutions because of long-term unit price performance or lower chares.
3. Reduces the impact of clients encashing units within their portfolio for less than they are worth.
4. Works in tandem with Dynamic Planner cash flow empowering fund and solution selection to be based on what a client needs and when not just what the funds will pay.
5. Same simple process as researching and recommending a Dynamic Planner risk profiled fund or risk target managed fund – costing advisers nothing extra in time, but adding all the value and reassurance they need that the client in decumulation has the best possible outcome.
6. No uncomfortable shocks at a next annual review. The risk and return assumptions of the agreed solution will have performed as expected even when the client introduces sequence of returns risk.
7. Peace of mind – for the adviser and the client in decumulation. They can have confidence – particularly during times of significant market volatility – that they are invested in the right solution at an agreed level of risk. A typical client in decumulation, most likely retirement, may not have any further opportunities to buy more units if their earning power, from their working life, is largely over.