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Article | 9-minute read

Hawks circling

February 2022

Rising inflation fears, geopolitical tensions and hawkish rhetoric from the Fed saw global equity markets enter correction territory in January. Despite the sell-off, our Chief Investment Office has maintained a mild overweight to risk assets this month. Find out why in our latest House View.

 

Our view

Once again, inflation, or more specifically the Feds reaction to more persistent inflation than initially expected, seems to be the main driver of markets. Commentary from Chairman Powell’s most recent press conference has been interpreted as being more hawkish, with his guidance to the market seeming to suggest that rates may rise sooner, faster, or even at larger clips than previously expected. This spooked an already fragile equity market which had lost some of the breadth of its rally late last year, leading to sell offs globally and higher yields, particularly at the short end of the curve.

The fear seen in markets is understandable - most indicators of activity see growth as weakening in the period ahead, which coupled with a reversal of unprecedented amounts of fiscal stimulus, and a less expansionary monetary environment, do present a level of vulnerability to asset prices, with investors concerned that a weakening in growth can quickly turn to a negative growth situation if managed inappropriately. That said, with most analysts having chastised the Fed for being behind the curve for so long, it’s interesting that they are now concerned it’s moving faster to try and catch up. Given the close to 80% rally in US equities since the bottom in March 2020, with similar strong returns in other markets, the pullback does suggest some profit taking is going on, rather than a capitulation, and we do not see recent moves requiring an unwinding of risk positions.

Locally, the RBA will have to raise rates as well at some point, but it doesn’t currently have the same inflationary pressures as the US (headline CPI of 3.5% vs 7% in the US). Additionally, with the local economy more sensitive to rate rises than the US (given our bias to variable rate lending), the RBA is unlikely to have to do as many rate rises to get inflation under control. Nonetheless, local bond yields moved higher in line with US markets as the risk off tone took hold.

The global economic recovery is continuing (albeit at a slower pace), policy stimulus is expected to be supportive (but not as stimulatory as last year), and inflation more persistent with central banks ready to take action. However, risks remain, with the reopening of economies still susceptible to an unpredictable Omicron variant, attempts from the Fed to control inflation potentially getting too aggressive, and the worsening geopolitical situation in Russia/Ukraine also raising concerns. These risks could see the recent weakness persist for longer than expected, but corporate results should provide some respite. We look forward to the earnings releases and outlook statements from corporates over the period ahead that should give further insights into the strength of the recovery. This could lead to an opportunity to take advantage of the weakness in equities, should we see near term volatility start to stabilise.

Volatility has lifted significantly in recent weeks

Market volatility line chart for 2021

Source: Bloomberg, ANZ PB&A CIO as at 31 January 2022

What this means for our diversified portfolios

We continue to be comfortable with a mild overweight position to growth assets, reflected primarily through developed markets equities where we believe more positive fundamentals should be supportive of asset prices. The drawdowns seen across portfolios have not been excessive, are reflective of a well-diversified approach to investing, and have benefited from exposure to, and the outperformance of ‘value’ style stocks that had suffered last year.

We hold a mild underweight to Australian bonds, which has benefitted from the sell-off in recent months. Yields have moved higher, and although we continue to favour a mildly underweight position, it is not as compelling as it once was. As a result, we have bought back some of the allocation to reduce the size of the underweight.

ANZ investment strategy positions - February 2022

Investment position
Asset class Reasoning
Growth Assets

 

Developed market shares

Global shares were hit hard in January as inflationary fears, slowing economic growth and the potential for a faster and steeper tightening cycle roiled markets. The US hit correction territory with technology and ‘growth’ stocks impacted most harshly by the prospect of higher rates.

This saw a rotation towards ‘value’ shares and strong outperformance from this segment of the market in early January. We expect this rotation to be largely done for now but there is likely to be further style rotations and heightened volatility across the course of 2022 - the CBOE Volatility Index (VIX), hitting its highest level in almost 12 months during January. Given this, we continue to hold a somewhat balanced approach to our portfolios with quality/growth represented by the US, and cyclical/value exposure via Europe and Japan.

Despite the hawkish narrative, policy remains accommodative, TINA (‘there is no alternative’) remains a prevailing theme, the business cycle in-tact and earnings accommodative. Unless we see a big deterioration in earnings then opportunities could present to increase our exposure to global shares in the coming months.

Emerging market shares

We are currently at benchmark to emerging market (EM) shares. Following significant underperformance over the course of 2021, relative valuations are currently very attractive, and the asset class shapes as perhaps the most interesting investment opportunity in 2022.

Like 2021, the performance of Chinese equities and news flow from the country will significantly dictate performance of the asset class. Currently countering attractive valuations are increasing geopolitical tensions, flow-on effects from China’s zero-Covid policy, and recent US dollar strength which historically displays a strong inverse correlation to EM equities. COVID-19 also remains a lingering threat given the poor inoculation rates amongst many regions.

We are closely monitoring these developments with a view to potentially upgrading our stance should these near-term headwinds subside.

Australian shares

We are currently positioned at benchmark to Australian shares and in 2022 see better opportunities abroad. While easing virus numbers bode well for the domestic economy to bounce back strongly from the impact of Omicron, the market is still heavily reliant on both financials and materials outperforming concurrently.

Financials should benefit from policy normalisation, however, materials are susceptible to rising rates, and a slowing Chinese economy. Despite a belief that the local market should produce positive gains over the course of 2022, we currently prefer global developed market exposure within portfolios where better earnings momentum and greater diversification exists

Listed real assets

Our current preference is to be benchmark listed real assets, the position a construct of our benchmark exposure to Global Real Estate Investment Trusts (GREITs) and mild underweight to listed infrastructure.

GREITs were among the top performing asset classes last year, bouncing from a major sell-off at the height of the global pandemic. This has seen valuations normalise, which alongside recent outperformance, frames our view that better opportunities currently exist in other risk assets. The asset class still provides an attractive dividend yield, diversifying effect for multi asset portfolios and hedge against inflation.

We commence 2022 with a mild underweight to listed infrastructure. Despite stronger recent returns and promises of large fiscal spends and investment in infrastructure, the long-duration nature of these assets, the outlook for rates and resulting potential of a rise in valuations kept the asset class subdued over 2021 and we see this continuing in 2022. The asset class remains an important component of multi-asset investing, offering a unique balance of defensive characteristics to withstand drawdowns as well as higher-beta traits to capture upside swings.

Foreign Exchange Hedge Ratio*

January was unkind to risk assets and the AUD wasn’t spared from the carnage, succumbing to hawkish rhetoric from the Fed which sent financial markets into a tailspin. In January, short positioning reached levels seen only twice in the previous two decades: the 2008 global financial crisis and the 2012 sovereign debt crisis. This may help partially explain why the AUD has not sold-off as much as expected given several share markets have entered correction territory. On a positive note, commodity prices remain fairly well supported and the domestic economy continues to exhibit solid momentum. Both should provide some protection for the AUD in the near-term.

Within our diversified portfolios we maintain our benchmark position to the AUD this month, albeit slightly below neutral. We prefer more developed market foreign currency exposure (in particular the USD) which should act as a form of protection in the event of any further equity market pull-back.

 
Defensive Assets

 

International fixed income

International bonds also sold off in January, having rallied at the end of last year. Inflation pressures, and the increased level of hawkishness from the Fed pushed US yields higher than their late October levels, with the 10yr yield trading over 1.8%, the highest it’s been in more than two years.

Our central case hasn’t changed since last month, although we are slightly more constructive on duration, we believe the market continues to underestimate the economic recovery and job tightening potential. Inflation is expected to be more enduring than initially expected, however, as economies reopen, the rebalancing of demand and supply-side dynamics should see inflation ease, although not pass altogether. Higher yields may eventuate as a result.

We continue to see global bonds performing better than local markets in the period ahead, predominantly due to the higher allocation to credit exposure in offshore markets, which should see spread products be well supported compared to predominantly sovereign exposures.

Australian fixed income

Following two months of falling yields at the end of last year, local bonds resumed their sell off, driven by ongoing inflation fears and reflecting moves offshore triggered by a more hawkish Fed, which saw yields back up near their highs of late October. The market is pricing close to four rate hikes for the year, which seems somewhat excessive given a more benign inflation situation locally. Nonetheless, we do expect monetary stimulus to continue to reduce, and as long as it does not materially dampen economic growth (and drive excessive capitulation in asset prices), it is likely the RBA will be eager to get rates to a more sustainable level.

The recent sell-off in domestic bonds saw our underweight drift further lower. While domestic bonds remain our least preferred asset class within defensive assets, the sell-off took us well below benchmark and any major shocks could unwind the gains made to portfolios earlier in the year. As a result of these factors we have rebalanced Australian bonds closer to benchmark but retain a mild underweight for now.

Cash

We hold a benchmark position in cash, having used part of our cash allocation to increase our domestic bond holdings following our last investment committee meeting. The position provides liquidity and risk reducing characteristics to portfolios.

 

Notes:

*Percentage of developed market and emerging market equities hedged from foreign currency into Australian dollars.

Tactical Asset Allocation is current as at 1 February 2022.

 

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