As investors look to the rest of 2021 after a bruising January, we see three interlinked factors continuing to dominate sentiment, namely inflation, interest rates (and other policy tightening) and volatility.
With inflation at multi-decade highs in the UK and US, all eyes have been on central banks to see how far they might go to bring soaring prices under control, with concerns we may see more rate hikes than expected a large contributor to recent volatility.
The Bank of England was first to act, with a rise from 0.1% to 0.25% in December and another 0.25% increase at the start of February. As expected, the US Federal Reserve refrained from any rate activity in January, albeit signalling an end to its asset purchasing, but the focus was on rises to come and a first step on the hiking path is all but confirmed for March. With US inflation at 7% and the jobless rate continuing to fall, concerns are rising about a possible 50 basis point increase in March and markets are pricing in a 94% probability of five 0.25% moves in 2022.
Needless to say, the impact on markets so far – on top of growing panic around the situation between Russia and the Ukraine – has been to weaken risk assets and continue to drive the growth to value rotation. Feasibly, we could see volatility continue until the March Fed meeting provides clarity on the volume and quantum of hikes and, in this environment, longer-duration growth stocks face a torrid few months.
Higher interest rates, theoretically, lead to higher discounting of future profits, so growth businesses with higher future profits (longer duration) are likely to see their valuations continuing to fall. We have also had a few tech darlings, including Netflix and Meta (Facebook), hit hard on lower earnings guidance and, more generally, there are suggestions that lockdowns led to an exceptional pull forward of demand in certain sectors and this will fade as we return to ‘normal’.
Despite the rotation, many value stocks continue to be very cheap; the UK, for example, remains a contrarian play despite a solid 2021 and holding up well so far this year as more of an ‘old economy’ market.
From a broader perspective, we try to look through short-term noise and identify investments we expect to outperform over the medium to long term. The past couple of years have provided an extraordinary environment for investors to navigate; at times such as these, many end up extrapolating short-term trends into something more substantial and this will often generate plenty of heat but little light. Over 2020 and much of 2021, many of the businesses that benefitted from the trend for people to stay at home enjoyed exceptional growth; some of that was justified by greater revenue, profit and prospects but some was probably overdone. When it comes to areas such as the US, we remain firmly in the overdone camp and have tilted our allocations away from expensive growth areas to less loved parts of the market, which represent better value.
From an equity perspective, that means a long-term underweight to the US and favouring markets such as the UK, Europe and Japan. Within bonds, meanwhile, we appreciate the direction of yields will be upward over time (as interest rates climb) but, as ever, the path will not be linear.
Looking forward, we would say that total returns from many equity markets, particularly the US, are likely to be lower this year after such a strong run post the initial Covid-inspired fall in March 2020. With the S&P 500 up close to 27% last year, history suggests that after a gain of at least 20% by the index, returns are comparatively muted over the following 12 months, with an average rise of around 8%. The extraordinarily narrow nature of recent US performance is also reinforced by figures that show just five companies (Apple, Microsoft, Amazon, Facebook, and Alphabet) contributed a third of overall S&P 500 returns over five years to end 2021. Debate over whether tech superiority can continue will rumble on but we suggest a situation where 1% of companies are producing 33% of performance seems unsustainable, particularly with a rising rate environment more challenging for longer-duration sectors.
For the foreseeable future, the narrative around markets will be all about rates: if they rise quicker and more than expected, (which is currently worrying markets), it could be tough for equities; if slower, that should be a healthier backdrop, especially for international and value stocks. But to reiterate, while we agree that large parts of the US market are prohibitively expensive, with many 'stay at home' companies valued as if the world is still at home, not everything is priced to perfection.
In a reflationary environment, we expect the rest of the world to outperform the US equity market, value stocks to outperform growth and small caps to outperform large. These outperformances will not all come at once, however, retaining prudent diversification could be a good tactic rather than making a significant gamble that one particular thesis pays off.
Notes
Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term. Some of the Funds and Model Portfolios managed by the Multi-Asset Team have exposure to foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The majority of the Funds and Model Portfolios invest in Fixed Income securities indirectly through collective investment schemes. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. Some Funds may have exposure to property via collective investment schemes. Property funds may be more difficult to value objectively so may be incorrectly priced, and may at times be harder to sell. This could lead to reduced liquidity in the Fund. Some Funds and Model Portfolios also invest in non-mainstream (alternative) assets indirectly through collective investment schemes. During periods of stressed market conditions non-mainstream (alternative) assets may be difficult to sell at a fair price, which may cause prices to fluctuate more sharply. This document is issued by Liontrust Fund Partners LLP (2 Savoy Court, London WC2R 0EZ), authorised and regulated in the UK by the Financial Conduct Authority (FRN 518165) to undertake regulated investment business. This blog should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. While care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust. Always research your own investments and if you are not a professional investor, please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances. 22/125
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