As we entered 2022, we spoke about the need for investors to brace for a more volatile market environment, after a period of relatively muted volatility in 2021. We knew also that central banks globally were beginning to shift away from record-low interest rates towards a normalisation in policy, an act that history informs us tends to be volatility-inducing as investors adjust to the new regime.
Fast forward to close to the half-year mark and both the inflation and monetary policy landscape has shifted dramatically, as have geopolitics. In January, financial markets expected the Federal Reserve (Fed) to raise interest rates just three times in 2022. In June, the Fed raised interest rates by 0.75% alone (the equivalent of three typical 0.25% moves), following increases of 0.25% in March and 0.50% in May.
Financial markets’ adjustment to the rapid evolution of inflation and interest rate dynamics so far this year is reflected in the recent volatility we have experienced. Inflation has thus far proved tricky for policy makers, economists and traders alike to forecast, and consensus views of a peak in US inflation in May did not materialise. However, there are positive signs in the cooling of durable goods prices and core inflation (excluding volatile food and energy prices).
Our investment team is always monitoring markets and looking for appropriate times to add to or cut exposure to different geographies and asset classes with the aim of keeping portfolios balanced and in line with your chosen risk profile. There will be short-term bouts of volatility which can make this incredibly difficult – such as recently, where not only have equities and bonds suffered, but other key assets like oil and the US dollar gave back some of their recent gains too.
We have covered the reasons for this volatility elsewhere, including in this month’s ‘View from the Investment Desk’, and it’s important that we are open and transparent with clients in what we are doing about it.
So, what have we done?
You may have seen notifications on the Nutmeg app about recent trades – though of course this is nothing new as we trade throughout the year. Here, we’ll explain the rationale behind these moves.
At our most recent monthly investment committee meeting we made the decision to reduce our exposure to US equities and medium-sized (mid-cap) UK company equities – the FTSE 250 index.
Those who follow our commentary, will know that the US remains a geography that we continue to place much faith in, especially given the sheer scale and robustness of American corporates and the entrepreneurialism that continues to be a defining feature of the world’s largest economy.
And, despite having reduced our exposure to US equities we still continue to carry an overweight position to this market relative to our benchmark. However, this is largely expressed through exposure to the financials sector, such as banks and insurers, rather than the wider US market. Why financials? We continue to believe that rising interest rates and continued economic growth favour this sector, as does the potential for corporate activity such as share buybacks and increased dividends.
Having reduced exposure to the US, we have put more money to work in Canadian equities. This is another market we have liked for some time having previously maintained a slight overweight, which we have now increased further. While Canada remains a relatively small market, we think it appears attractive from a long-term valuation perspective, as well as maintaining a sector composition that is appealing in the current environment: a high exposure to both financials and commodity related sectors. In addition, through this position we have increased the Canadian dollar exposure in portfolios – this is a key commodity currency, which means that it tends to move in tandem with world commodity prices
The Canadian equity market also has some parallels with large-cap UK equities, in particular the FTSE 100 index, which also has big constituents involved in the financial and commodities related sectors. Here we have increased our allocation to the FTSE 100, which we also find appealing given its tendency to fair better than other markets during volatile periods (as has been the case in 2022 so far).
The case for emerging markets
Lastly, we have reduced our underweight to emerging market equities, which have been out of favour for more than 18 months. We believe that some of the headwinds that have kept us cautious on these markets have now started to ease.
In particular, China’s economy has begun to reopen after a period of Covid lockdowns, which is good news for the whole global economy which still relies on the Asian superpower as a manufacturing hub. Policy in China is also now pivoted towards sponsoring economic growth, while regulatory risks around the Chinese technology sector appear to be receding. A key reason to remain underweight emerging markets at the turn of the year was the potential for the US dollar to strengthen. Again, this has so far played out, and given the extent of the move in 2022, the balance of risks has evolved.
As always, there remains a risk especially with regards to the Covid situation in China and the impact of the strong US dollar on importing countries in emerging Asia, but being underweight emerging markets has become less attractive in recent weeks.
Our view on bonds
We have carried a large underweight to government bonds for the past two years, believing that while exposure to the asset class remains essential for balancing risks within a portfolio, there have been better growth opportunities within equities, and that the potential return profile for bonds did not adequately reflect the risks.
However, as government bond assets have delivered further losses in recent weeks, we have started rebuild a position where we believe it is attractive to do so. While we have typically held around a third less government bond exposure than we would expect to over the long term, we’ve increased our weight marginally to recognise the higher bond yields the past months have delivered.
To be clear: we remain underweight government bonds across our portfolios, but as markets move, we will remain active in rebalancing our positions where we believe it is favourable to do so.
A clearer future
The first half of 2022 has been challenging for all investors globally, not just us at Nutmeg. A perfect storm of rising inflation, pressure on central banks to stave off recession, and a war in Europe to contend with, has led to the rare scenario where both equity and bond markets have taken a downturn.
These are not problems that can be addressed overnight, though recent macroeconomic data has continued to be supportive of positive underlying economic activity. As ever, the team is monitoring a wide range of macroeconomic and financial market indicators, and we will continue to take a medium-term view and adjust our portfolios when the evidence points to better opportunities for our clients.
For those worried about how market movements might impact your financial plan, or who wish to discuss their individual financials goals with an expert, consider contacting the Nutmeg wealth services team who will be able to point you in the right direction.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.