The start to 2022 hasn't been smooth for either bond or equity investors. The month of January saw the US technology-focussed NASDAQ index down 9%. Meanwhile, other areas of the market that had seen significant price growth in 2021 experienced an even rougher ride in January with bitcoin (in US dollar terms) down 17% (and -43% from its November peak) and Goldman Sachs' proprietary Non-Profitable Technology stock index off 19% (and -50% from its February 2021 peak). Even global and Australian bond investors weren't spared with the Barclays Global Aggregate Bond (in AUD) and AusBond Compositive indices falling 1.6% and 1% respectively in January - significant moves for an asset class that's typically expected to deliver 2-3% across an entire year. It's worth noting however that since its trough on the 27th of January, the NASDAQ has already rebounded 8%.
This is a timely reminder that volatility in markets can and does happen! In fact, it's normal and we view it as healthy in the context of the remarkably smooth, rising market we saw over the bulk of 2021, resulting in certain pockets of the market beginning to trade on overly frothy valuations. For astute long-term investors, pull backs of this nature should be viewed as opportunities.
Without foreseeing the precise timing of this volatility, Redwood's view on the prevailing equity valuations saw us position portfolios modestly underweight their target allocations. Importantly, this position was held prior to the recent bout of volatility. Further, our surplus cash and liquid asset holdings now afford us the ability to be patient and selective in deploying this capital back into equities.
However for a number of reasons that we discuss below, we believe the recent volatility in markets is unlikely to be the only opportunity we see to deploy capital over the next twelve months.
Before assessing the outlook, it's worthwhile discussing what was behind the recent pullback. Throughout most of 2021, consensus was that the recent uptick in inflation was going to be temporary in nature given economies were progressively re-opening from their COVID-induced lockdowns. While there was an incredible surge in demand as households were released from the confines of their homes, supply chains were experiencing interruptions as a result of broadening COVID infections across the workforce. The expectation was that these dynamics would normalise.
However towards the end of the year, central banks started to change their outlook. As illustrated below, the US market in October was effectively expecting no interest rate increases by December 2022 yet over the following 4 months it had priced in a full 1% lift in rates!
Inflationary pressures were now being seen in a broader cross section of the economy (particularly in the US) and alongside falling unemployment, the justification for highly accommodative policy settings was fading. Rate increases in 2022 were a real possibility. Within the space of a few months, bond markets priced in multiple rate rises over the next twelve months, materially impacting bond prices. However equity investors were a little slower to the party, instead pricing in this expectation over the course of January.
Looking forward, we feel markets have now largely priced in the rate increases we are likely to see from the US Federal Reserve and Reserve Bank of Australia over the course of 2022. Unfortunately that doesn't mean markets are void of other potential triggers for volatility. 2022 will also bring a number of other issues for markets to contend with including (but not limited to):
- An Australian Federal election, due to be held before the end of May;
- Tensions between Russia and Ukraine;
- The Chinese central government's rolling trade disputes, ambitions to 'unify' Taiwan along with managing the ongoing issues emanating from the failure of its largest property developer, Evergrande;
- The ongoing evolution of the COVID pandemic including the prospect of new variants with unexpected health and economic consequences; and
- A tougher corporate profit outlook. Profitability was buoyant in 2021, in part due to the flow-through of the massive fiscal stimulus unleashed in 2020. This wave of stimulus is now fading and corporate revenue growth is slowing while cost pressures remain. Profit growth will be tougher in 2022. We expect to get a clearer picture over the course of February as companies report their semi-annual results.
So how are we managing portfolios in light of this environment?
Firstly as we've highlighted, our portfolios remain modestly underweight growth (equities) relative to their targets. Importantly within our global equity allocations, the majority of our positions have been positioned to benefit from a depreciating Australian dollar. Indeed this proved a valuable buffer against the pullbacks in global equity markets over January. The 3% depreciation of the Australian dollar (against the US dollar), partially offset the fall in share prices in offshore markets.
As we gain comfort with the inflation and interest rate expectations priced into bond markets, we continue to assess the opportunity to add fixed rate bond (also referred to as duration) exposure. However we will only do so once we are satisfied there is an adequate margin of safety. When added at the appropriate time, duration can provide important diversification benefits to a portfolio, namely income and capital preservation attributes.
Notwithstanding the potential for their share prices to be impacted over the short-term from changes in interest rates, we retain a preference for high quality infrastructure investments. Not only do they provide an important hedge against accelerating inflation (given they can typically increase pricing at or above the rate of inflation) but they also provide portfolios with an attractive and reliable source of income.
As it stands today with a number of uncertainties on the horizon, we believe the range of potential outcomes in the year ahead feels wider than usual. Consequently, we don't feel it's appropriate for us to be making sizeable investment decisions. As a general rule, equity markets find the going tougher when financial conditions are noticeably tightening (ie. interest rates are rising). Our approach to portfolio management affords us the ability to be patient, looking for opportunities at appropriate times that will add value.