The Investment Backdrop in 2022: Hawkish Fed and Rising Inflation

In my role as CIO，I get to meet different kinds of investors. There are those with diversified portfolios of course，but many clients I speak to have a very clear bias towards one asset class: either equities or bonds. The biggest challenge for investors of all stripes this year is that there have been few places to hide. Global equities have fallen almost 20%，while the ramp up in interest rate hike expectations has also hit bond markets hard. Gold offered some respite for the first couple of months，but the precious metal has fallen 10% from those highs. The good news is that the simultaneous decline in asset classes could be a silver lining for investors when it comes to planning the next course.

What we saw this year is rare. Normally，high quality bonds appreciate in value if equities fall sharply. Equities usually fall at a time when people are becoming more concerned about slowing economic growth，which usually encourages central banks to ease monetary policy，which in turn pulls bond yields lower (and bond prices higher). Meanwhile，when bond prices are falling (i.e. bond yields are rising)，investors are normally becoming more positive on the outlook for growth，which is positive for corporate earnings growth and equity prices.

Silver lining for non-diversified investors

In one way，this inverse relationship between stocks and bonds is positive for investors as it means that losses in one part of the portfolio are offset，at least to some degree，by gains elsewhere in the portfolio. Indeed，this is the very reason why we recommend a diversified portfolio – diversification enables investors to smooth the performance of their investment and reduce the risks of being consumed by the urge to sell at exactly the wrong time.

However，for investors with concentration in the ‘wrong’ asset class，this divergent performance can be very painful. Not only would they have lost more money than they would have done if they had a diversified portfolio，but the cost of remedial action (i.e. diversification) would have increased as the other asset classes would have appreciated in value. If diversification requires selling current holdings (assuming there is no cash on the sidelines to invest)，the cost will be even greater because the investor will get less for the asset being sold (relative to history) and will pay more for the asset being acquired.

So why is this time different? To answer this question，we need to look at why equities and bonds have both fallen in value this year. The one-word answer: inflation! This time，the major concern is that high inflation will force central banks to tighten monetary policy to such a degree that it will choke off economic growth. Bond investors dislike inflation and higher interest rates. Meanwhile，equity investors abhor recessions. This has resulted in equity and bond prices falling in tandem this year.

The good news is that central banks might be winning the war against inflation，with inflation expectations showing tentative signs of peaking. So，what should investors with high concentration in a particular asset class do? They should use the opportunity to diversify into other asset classes. For sure，the investor will have to recognise some loss as he/she sells some assets to reduce concentration，but the good news is that the asset being acquired is also on sale and therefore the cost of the ‘medicine’ to fix the imbalanced portfolio is now much lower.

Of course，those who have been overweight in cash this year are in the best position，assuming they have not been in that position for too long. With equities and bonds both going ‘on sale’，this is a great opportunity to at least start increasing allocations to a diversified portfolio. This does not need to be confined to traditional asset classes，such as listed bonds and equities. The allocations could also include private assets，for instance private credit and private real estate. While cash has held its value in nominal terms，in real terms it has lost value to inflation for many years，especially this year.

Therefore，while it is easy to focus on the empty half of your glass as an investor these days，for those who have learnt the hard way that they should change their investment approach，they should take comfort that the cost of doing so is much lower than it would normally be. It would be a real shame if investors failed to seize this opportunity to own a more diversified and balanced portfolio - starting today.

Beware of negativity bias as markets go on sale

I have had two instances in the past few weeks when members of a live audience shared their strong conviction in a bearish stock market outlook. One member gave a very precise 10-year forecast for the S&P 500 index (-2% per annum)，while the other was more vague in terms of time horizon or the specific equity market he was referring to.

I have two issues with this，both of which are related to the conviction they held in their views. First，people with high conviction are very persuasive and compelling. Negativity bias – whereby we tend to attach a higher weight to negative information or views – merely exacerbates this. As such，they may have an outsized impact on the audience’s investment decisions. If the negative views are wrong，it would undermine investors’ ability to achieve their financial goals.

Second，people with high conviction infer that they know what is going to happen，which is definitively not the case. The outlook is probabilistic and not known by anybody ahead of time – you，me or other esteemed finance professionals.

Of course，this is not to say they will be proven wrong. I can paint a scenario whereby equities lose value over the short run. This could go as follows: the lockdown in China extends through the rest of the year，while Europe decides to disengage from Russian energy supplies. This would keep supply-side inflation elevated，which，together with tight labour markets fuelling wage pressures，could force dramatic monetary policy tightening around the world.

Even without a recession，this could be challenging for markets as history shows that equity market valuations (e.g. price-earnings ratios) are lower during periods of high inflation and interest rates. If you were to add in the chance of a recession，as the central banks tighten policies too aggressively，earnings would be hit dramatically，and equity markets could decline even further in the short run.

Making a case for a 10-year decline in equities is harder，in my opinion，as earnings tend to rise over the course of the cycle and companies pay out dividends during that period. High inflation would likely be reflected in higher earnings as well，especially over longer time horizons. Of course，there have been instances when 10-year periods generate negative returns，but it is very rare and is usually very sensitive to the start and end dates i.e.，if you move the start and the end date by a year，the outcome is