Global Asset Tracker: Steady hand required in era of rising volatility

Respondents to PWM’s seventh annual asset allocation survey recommend clients prioritise risk assets while keeping portfolios well diversified [note this article went to press before the Russian invasion of Ukraine]

While expanding monetary policy and extraordinary fiscal support, coupled with robust economic recovery and solid corporate earnings, propelled stocks to record levels in 2021, economies and markets are expected to be on a path to normalisation in 2022. This outlook brings significant implications for asset allocation.

“We expect 2022 to be a year of normalisation from all fronts: the pandemic, economic growth, monetary and fiscal policies and returns,” says Julien Lafargue, chief market strategist at Barclays Private Bank. “Equities remain better positioned than bonds but diversification and selectivity are key in an environment that will remain volatile.”

Economic growth this year is still expected to reach above pre-pandemic trend, with robust, but past their peak, earnings leading to more muted returns.

The main headwind is inflation, which is at a multi-decade high and has forced central banks, led by the US Federal Reserve, to catch up and get to grips with price pressures.

Prospects of rate hikes led the US stockmarket to suffer its worst January since the global financial crisis.

The ongoing tug of war between inflation and monetary policy tightening concerns on one side, and solid economic and corporate fundamentals on the other, reinforced lately by strong earnings, is likely to keep volatility elevated this year.

Moreover, the monetary regime change is occurring against a very fluid backdrop, complicated by the pandemic’s grip on the economy, rising geopolitical tensions, with growing fears of the threat of a larger scale Russian invasion of Ukraine, the persistence of high energy prices and supply chain disruptions.

In this turbulent, highly volatile environment, investors should prefer risk assets, seek unconventional income and must make sure their portfolio is greatly diversified across all asset classes, including alternatives such as private markets, commodities, real assets as well as hedge funds.

Clients should remain invested and “even take advantage of opportunities to add quality, oversold and undervalued names to their portfolios,” says Stéphane Monier, CIO Private Bank at Lombard Odier.

“Historically, equities have been volatile in the early phase of monetary policy normalisation, but then tend to stabilise and rally, rather than signal the end to a bull market. This tendency to rally through a hiking cycle is logical, as it reflects robust economic growth,” adds Mr Monier.

Key findings from PWM’s 7th annual Global Asset Tracker study highlight investment professionals’ constructive views on economies and markets.

Conducted in January, the research canvasses investment and asset allocation intentions of chief investment officers (CIOs), chief strategists and heads of asset allocation at 52 institutions, managing a combined $15tn in client assets.

Our respondents’ strongest conviction is that clients should prefer equities over fixed income, and favour risk assets in general, as negative real rates are here to stay as inflationary pressure rages on. Historically, negative real rates stimulate the economies and are commonly associated with strong performance in equity markets.

Global stocks are expected to generate high single digit returns in 2022, as central banks normalise their monetary policy in a gradual way.

Inflation is also expected to retreat to more tolerable levels during the year, as demand shifts back from goods to services, easing supply chain pressures and price hikes, while base effects in energy prices become more favourable and the pandemic becomes endemic.

With liquidity in shorter supply, selectivity is paramount and will reward active management, which 87 per cent predict will outperform passive management in this new cycle. “Unlike in the early stages of the bull market, when the rising tide of liquidity lifted all boats, as we enter into a more mature stage of the market cycle, we expect greater dispersion in the equities space and investment selection will become key,” says Jean Chia, CIO at Bank of Singapore.

Despite a brighter outlook for active management, respondents expect growing client asset flows into sustainable ETFs (89 per cent), and thematic ETFs (60 per cent) this year (see Fig 9).

There is also a strong call for clients to remain anchored to their strategic asset allocation.  Trading in periods of high volatility can be very damaging to long term returns, as the worst days in the market are typically followed by some of the best, says Katie Nixon, CIO Wealth Management at Northern Trust.

“With a constructive outlook for risk assets, we urge investors to fight the impulse to try to time the market, but instead take the time to reaffirm financial goals and align strategies to those goals and then stick with the plan, despite the potential near term challenges,” she says.

Adapting portfolios

The monetary paradigm shift requires asset allocators to ensure client portfolios are ready to face headwinds.

After years of “lowflation”, inflation rates will become higher for longer, and investors need to hedge their portfolios against inflation risk, particularly assets invested in sovereign bonds and in corporate credit, which are vulnerable to prolonged higher inflation rates, says Edmund Shing, global CIO, BNP Paribas Wealth Management.

They should be looking at inflation-protected bonds, even though they are “a little expensive”, and invest in absolute return and flexible bond funds.

Importantly, they also should be invested in equities that can benefit from a higher pricing and inflation environment, for instance cyclical stocks, and value stocks and sectors. Investors should also have exposure to commodities, which typically do well in a higher inflation environment, notably precious metals and base metals which are used to make batteries.

In the equity space, the most sought-after by our panel are high quality stocks with pricing power, able to withstand pressure on margins caused by higher prices, thanks to their strong brand, a superior product mix, or high-value content. (see Fig 8).

Value strategies, which tend to be better insulated to higher interest rates, are expected to provide some of the most attractive risk-adjusted return opportunities this year, but must be balanced with growth stocks, which tend to be more sensitive to higher rates.

While the recent sell-off  hit growth and many tech stocks especially hard, because of the long duration of their earnings, value stocks boasted an historical outperformance versus growth during January.

As a result, financial, energy and materials are seen to be the most attractive sectors this year, while defensive sectors such as healthcare and relatively defensive strategies such as dividend paying stocks should also find their way into portfolios (see Fig 10).

While stocks will continue to provide positive returns, supported by healthy earnings and global GDP growth, the new environment requires a change of focus, believes Lars Kalbreier, global CIO, private banking, Edmond De Rothschild (EdR). He believes there may be “a change in leadership, a shift from mega cap tech stocks to cyclical stocks,” which typically benefit from the economic recovery.

While the US market outperformed  global markets in 2021, the baton may be passed between regions, as Europe and China are likely to perform better than the US this year, he predicts.

Divergence of monetary policy across markets is a key factor in the market outlook.

Although the Fed is beginning to tighten, The People’s Bank of China is easing and the European Central Bank (ECB) has remained more accommodative, which explains why eurozone and China equities are favoured by 73 per cent and 69 per cent of respondents respectively. Just under a third, including some major US banks, view US stocks as attractive or very attractive.

Secular growth

Bank of America is still “fairly optimistic” on equity, and especially US stocks. With quantitative tightening “what is happening in the marketplace is a valuation revaluation,” says Niladri Mukherjee, head of portfolio strategy, chief investment office, Bank of America Merrill Lynch.

“There is no doubt that US equities are expensive on an absolute basis if you compare them to their own history. But the PE of the S&P 500 has moved lower given the recent sell-off so there has been a resetting of expectations,” he says. Some “valuation compression” will likely continue “a little bit more going forward”.

But comparing valuation of US equities to bond yields, US stocks still look reasonably valued. Also, structurally, US companies have become more profitable than
10 to 20 years ago, which adds to high-valuation multiples.

Importantly, US stocks have high exposure to secular growth-oriented industries, such as  technology and communication services as well as parts of the healthcare sector, which together account for more than 50 per cent of the S&P500.

“When you think about secular growth opportunities in technology and communication services, the US has been the place to go for global investors, which contributes to high multiples of the US stockmarket,” says Mr Mukherjee.

But advice to clients is to continue to balance growth and value. Especially as financial conditions tighten, investors should avoid more speculative areas of the innovation marketplace, which have questionable long-term business franchises, are trading at a high PE multiple and are long duration in nature. This means a significant part of the value is their future earnings profile and they are more sensitive to interest rate rises.

“When the Fed liquidity conditions are rising, everybody gets the trophy. But when liquidity conditions pull back, that’s when the fundamentals come through, and the high quality nature of companies and the sustainability of business models are rewarded.”

The focus should be on companies exposed to digitalisation of the global economy, artificial intelligence, robotics, software, factory automation, and are leaders in their own industry, with free cash flow and high quality balance sheets, says Mr Mukherjee.

Long-term thinking

The sell-off is also creating opportunities for long-term investors. JP Morgan Private Bank took advantage of the correction in January to increase equity overweight from 5 to 8 per cent, mainly to the US, the bank’s preferred region for long-term investing, as well as Europe.

In an environment of slowing but still strong growth, where central banks are accelerating policy normalisation and inflation remains sticky, “valuation discipline is key”, says Grace Peters, head of investment strategy, EMEA at JP Morgan Private Bank.

This means “having access to durable growth at a reasonable price, making sure to have a high degree of confidence around the corporate profit stream, and to not pay too much for that”.

The bank wants to avoid ‘concept stocks’, mainly found in the mid and small market cap spectrum, to focus on “quality growth companies with strong balance sheets”, in sectors such as technology or pharma.

“We believe in digital transformation as a mega trend,” she says. Because of recent volatility, the US market has become less expensive and the derating of the technology sector has been more severe. “In the large cap tech space, many companies are cash rich, can afford to do share buybacks, grow dividends and reinvest for the future, and valuations now look attractive,” says Ms Peters.

The luxury sector in Europe, and more generally consumer discretionary, is also appealing. “The pandemic has generated a big wealth effect, with savings going to older and wealthier households. This means premiumisation or luxury is a positive theme for this cycle.” The interest for iconic products, whether it be watches, jewellery or handbags, is linked to growing attention to sustainability, fuelled by the pandemic, as people want to be more sustainable in their choices, adds Ms Peters.

Looking to China

The US bank has also been adding to on-shore Chinese equities, which are believed to offer “a good entry opportunity”, after last year’s sell-off.

While Asian ex-Japan equities are the most favoured in emerging markets, most respondents (69 per cent) have a positive outlook for Chinese equities, especially for the second half of the year, as structural reforms start to take effect.

Chinese growth will moderate this year, but the country has capacity for easing its monetary policy, and inflationary expectations are not as high as in the US and Europe, believes Bank of Singapore’s Ms Chia.

China dialled up the regulatory burden significantly last year with the final goal of delivering ‘common prosperity’. The process will continue but will not be as intense.

“The next phase is really to look at where China can invest to broaden growth to achieve objectives of common prosperity. That will include investments in digitalisation, 5G and AI, because there is a desire to win the race on the digital front.”

There will also be more emphasis on the transition to a greener economy, with investments in green infrastructure, green energy and electric vehicles, all sectors likely to grow at the expense of traditional industries.

“If the macro-environment is conducive, it will provide potential tailwinds for the market in general, but we recognise we are not out of the woods yet,” says Ms Chia.

“What is holding China back is the zero-Covid policy that has hampered reopening and that’s still a wild card. If anything, that could be an upside surprise, if China chooses to loosen up on that front,” she says, warning the next six months will be critical for the Chinese economy.

Thematic approach

Structural, long-term investment themes have a key role to play in client portfolios (see story on page 18). Most private bankers (84 per cent) believe clients should gain greater exposure to strategies able to capture upside in irreversible trends.

Tech innovation, climate change and sustainability continue to be the investment themes that most resonate with clients (see Fig 11). Focusing on longer term goals may also help investors face rising market turmoil. Indeed, in these very unpredictable times, the only certainty is that market volatility is here to stay.