We have seen some shifts in consensus thinking; notably in terms of slowing growth and recession, to recognising that rates will be higher for longer. As a result, we have seen some dramatic market turns. Defensive fixed income has, once again, had a tough time but equities have also shown mixed performance. The narrow artificial intelligence theme has driven large-cap US equities, but a lot of other equity markets are flat to down on the year.
Cash can be part of an investor’s solution. Our concern would be that holding cash carries risks, particularly reinvestment risk, where today’s rates may not be available in the future. Typically, when cash rates go up, after a while they come down again. Additionally, choosing cash means potentially sacrificing opportunity as asset prices often move when cash rates move, so if an investor is sitting on cash, they miss out on potential future return opportunities. On the flip side, the biggest benefit of cash is the cushion that it provides. If you can earn a decent yield on cash, you can consider taking a bit more risk elsewhere than you might otherwise have done in recent years.
Higher rates typically move asset prices and push average yields up across markets. For income investors, this creates opportunity. Higher rates also have macro-economic consequences. So, the question is, have rates gone up enough, are they going to start to squeeze economies and lead to recession? Typically, monetary policy is a blunt tool. The Federal Reserve and other central banks are trying to fine-tune the economy with a hammer and that easily causes accidents. The implications lead to both opportunity and risk.
Investors need to rethink fixed income. Many investors have grown up with two protracted trends: a bull market since the 1980s, which flattered fixed income returns; and, for the last 20 years, a negative correlation between bonds and equity markets, which was useful for diversification. Neither trend will necessarily hold true in the future and so investors may need to be more thoughtful about how they build their portfolios.
Also, while different parts of fixed income will be useful at different times, other parts may need to be avoided for periods of time. Investors should cast the net wider and look for fixed income-like assets elsewhere in the asset‑class spectrum. For instance, equities that pay reliable dividends could be an alternative to inflation-linked bonds.
Typically, geopolitics are a driver of risk. They do not generally change fundamentals (although they can), but they can drive volatility. So, portfolios must be able to cope with risk. The main thing is to keep focused on the underlying economies.
It is clearly an uncertain world and has been for some time. We tend to think about the world in terms of scenarios. So rather than saying one thing is going to happen and hope it does, we aim to construct portfolios that can withstand diverse outcomes.
Our central case is more pessimistic than the consensus, which anticipates a soft landing globally, with well-behaved inflation and, ultimately, peaking interest rates. However, this optimistic scenario is a little too neat. Rapid and substantial interest rate hikes could likely lead to a recession. In that scenario, it’s advisable to hold interest rate-sensitive assets, particularly in areas where interest rates are likely to be peaking and have room to decrease significantly.
There are a variety of countries across the developing and emerging world that are beginning to feel the pain of higher rates and could decline significantly. Bonds in those markets should do well. We also think there are opportunities in specific equities benefiting from lower rates and bolstered by strong underlying cash flows that support dividends.
However, the world may align with the consensus view, or take a more extreme turn. If the consensus is right, risk assets and growth assets are likely to perform well. In those circumstances, call options on equities can provide coverage, and we find them reasonably priced at the moment. But the flipside is if economic conditions become too strong and central banks respond with aggressive rate hikes, the focus will shift to reducing risk and protecting capital. Nonetheless, we believe there will always be opportunities to add value and capture returns.
General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Government securities exposure: The Fund may invest more than 35% of its assets in securities issued or guaranteed by a permitted sovereign entity, as defined in the definitions section of the Fund’s prospectus. Emerging and Frontier market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems
