While we were never in the inflation is transitory camp, we were certainly not expecting the kind of readings we have seen this year which have confirmed prices in the US, UK and Eurozone are increasing at their fastest rate in four decades. Not surprising then that when the latest US CPI data registered a decline for the first time since 2020, markets breathed a collective sigh of relief.
Interestingly, following a horrendous first half of the year, longer dated government bond yields have declined quite significantly over the last few weeks. That might seem strange given that until the latest US inflation numbers both the CPI prints and strong employment data suggested that prices are likely to stay way above central bank targets for a considerable length of time.
Of course the decline in government bond yields may be down to the market pricing in a significant slow down in economic activity next year (we think this is likely), but that doesn’t explain the rally we have also seen in riskier assets such as corporate bonds and equities. It may be that bearish sentiment towards the end of the second quarter just got too extreme and that we are just witnessing some sort of mean reversion. However, what is certainly true is that equities and government bonds in many countries and regions remain positively correlated and this causes all sorts of problems for hybrid equity/bond (60/40 etc.) models that have been so reliable over the last forty years or so.
While the recent lower US inflation number is to be welcomed, it is only one set of data and the Fed and many other central banks are still a very long way from getting prices under control. In the US, CPI at 8.5% is over four times the Fed’s target while in the UK and Eurozone, inflation is likely to increase further in the short term.
Against this backdrop, it seems very likely that interest rates will have to increase further and monetary conditions will continue to tighten. This has been a headwind for both equities and bonds this year and may continue to be so for several months.
Against this backdrop, our portfolios remain relatively defensive with equity allocations below their historic norm, while we continue to favour allocating away from the US where both equities and the Dollar appear overpriced and overowned. The UK remains one of our favoured markets although valuations are attractive in many other areas including Europe, which has suffered particularly hard from the war in Ukraine and Emerging Markets, which have not enjoyed tighter US monetary policy and a surging Dollar.
Within our bond portfolios, we have not materially changed our exposure although we did marginally increase our allocation to emerging market debt (EMD) in June. EMD has had a truly dreadful year for a number of reasons but at least we are now being compensated with a very significant increase in yield. The majority of the duration in our bond portfolios emanates from our EMD exposure but elsewhere duration remains very low with a meaningful exposure to floating rate debt. These assets haven’t been immune from the poor sentiment in corporate bond markets generally but we expect higher coupons over the next year or so as interest rates continue to climb.
UK commercial property has been one of the stand out asset classes of 2022 so far although even here July saw a fall in prices for the first time since March 2020. Having increased our exposure quite meaningfully early last year, we have taken some profits recently. However, the areas we favour which include care homes, primary healthcare and student accommodation continue to offer attractive yields with dividends expected to increase over time.
Finally, with government bonds no longer the reliable diversifiers they once were, alternative assets remain an important part of the overall portfolio mix and we expect this to remain the case for the foreseeable future. We own a number of complimentary strategies which not only have a low correlation with each other but more importantly, both equities and bonds.