The ‘strange multiverse’ of high short-term inflation for multi-asset investors

The global economy is evolving rapidly and higher inflation is driving market volatility. In mid-2020, in the midst of one of the greatest crises, fixed income traders were pricing the average 5-year inflation rate in Australia at around 0.5% per annum. In contrast, the latest Australian Consumer Price Index has risen by 5.1% year-on-year1. Central banks are reacting to higher than expected inflation by rapidly increasing interest rates. What does higher inflation and interest rates mean for investors in the Russell Investments Multi-Asset Managed Portfolios?

So far, it’s meant greater volatility and lower returns. After a period of growth asset strength in 2021, equity and bond markets are posting negative returns. In 2022, the biggest losers have been long-dated government bonds and technology stocks with high earnings expectations. The biggest winners have been commodities and listed infrastructure.

How have the portfolios fared in 2022?

Our multi-asset managed portfolios held lower allocations to government bonds and U.S. technology stocks, and higher allocations to stocks with cheaper valuations. This has been a positive for performance, reducing some of the losses.

Also adding to performance has been allocations to active managers such as Allan Gray (Australian equity active manager with overweight positions to energy) and alternative managers such as Putnam and Amundi (managers investing in volatility markets). We significantly reduced exposure to high yield and emerging market debt within the dynamic real return strategy within the portfolios in early-2021. Lastly, we have reduced exposure to equities in recent months.

What are some potential changes in coming months?

Our global investment process focuses on the cycle, valuation and sentiment of markets. For equity markets, it became clear in early-2022 that the near-term cycle was about to become more challenging, with central banks withdrawing liquidity and raising interest rates.

We still maintain a positive view for equity markets over the medium-term but we are expecting a continuation of this environment of higher volatility. Valuations are back to more reasonable levels, however we’re patiently waiting before redeploying capital. Markets are oversold on our sentiment indicators but we’re cognisant that much of the year-to-date weakness is coming from the bear market in technology stocks and there could be further weakness in other sectors to come.

For government bonds, there have been significant losses in the first half of 2022. However, it’s starting to make sense for investors to consider adding back to government bonds as a diversifier. We believe it is likely that government bonds will rally if there is a downturn in the economy.

The bottom line

We continue to monitor the volatility in financial markets for any opportunities that might emerge. The biggest risk to adding both government bonds and growth assets is the potential for a prolonged period of stagflation, where inflation remains very high, and growth falls significantly. This risk is a possibility but not part of our central case. This is the reason why we want to be very patient when adding both equities and bonds and remind our clients that investing requires a long-term focus. In a period of heightened uncertainty, it’s important to have a tried-and-tested dynamic process and use active managers that can potentially take advantage in times of panic and stress.

1Source: Australian Bureau of Statistics