Re-learning the lessons of investing in a time of war and inflation
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Re-learning the lessons of investing in a time of war and inflation

The start of 2022 has seen markets shocked by unfamiliar events: war in Europe and sustained inflation in developed economies. Penning these words in mid-March, this all sounds negative, but the war could end as swiftly as it began – we just don’t know. That means there appears to be little mileage in taking big bets, when we could wake up the next day to find the situation transformed once again.

Instead, I intend to focus on what we do know about the outlook for markets and economies in the face of inflation, and how I think that leaves a positive outlook for equities. My assessment is that inflation and interest-rate hikes will dominate this year and, while that raises the risk of a recession in 2023 and beyond, equities should perform reasonably, especially by comparison with bonds.

Inflation was already a problem from the start of 2022

This was largely as a consequence of the pressures put on still-disrupted supply chains by the global economic recovery. Even if the war in Ukraine is resolved tomorrow, the disruption of commodity prices from sanctions and destruction will persist. But rather than stagflation, we are seeing continued economic growth and, in the US, a tight employment market driving wage growth.

The risk of recession needs to be taken seriously, in 2023 and beyond

As a consequence, the US Federal Reserve raised interest rates this month and indicated that there were six more increases to come. While that barely gets the interest rate above 2%, it still represents a concerted tightening of monetary policy. History tells us that, of the 12 interest-rate-tightening cycles in the US since World War Two, 10 ended in recession and only two in a ‘soft landing’ for the economy. So, we need to accept that the risk of a recession in 2023 has increased, though I still think it remains an outside chance at this stage.

Active managers have taken a hit as growth stocks and small-caps have suffered

So far in 2022, financial assets have fallen, while commodity prices have risen. Performance figures also show a clear reversal of previous trends within equity markets. The UK FTSE 100, buoyed by oil majors, is flat, outperforming most major international equity markets. Within the UK equity market, small- and mid-caps indices are down around 10%, while investment trusts focused on technology, like Scottish Mortgage Investment Trust and Polar Capital Technology Trust, are down by as much as 30%. The only way to have outperformed is to have had overweight positions in the largest companies in the index and been underweight the areas that have generated the best returns over the past decade. So, it is not surprising that many active managers have underperformed in the year to date.

However, the fundamentals for equity markets are supportive. Corporate earnings are strong, though the outlook becomes tricker in the latter part of the year, as company managements will have to cope with sustained inflation for the first time in decades. Equally, equity dividend yields are attractive, with the FTSE All Share currently yielding 3.3%, still well ahead of gilts. We are also seeing decent dividend growth in recent announcements, though I think it is unlikely to match the peak of 8% inflation forecast by the Bank of England.

Sticking with equities and keeping growth and technology in the portfolio for the recovery

Rising interest rates and inflation, combined with economic growth, do not necessarily create a bad environment for equities, especially by comparison with the outlook for bonds, which looks dreadful. Therefore, while I have shifted the portfolio towards more value-oriented trusts, like the City of London Investment Trust, which focus on profitable and dividend paying companies, I have diluted rather than replaced the commitment to growth and technology. That should not only provide better performance if political risks ease but should maintain exposure to transformative growth over the longer term.

30 March 2022
Peter Hewitt
Peter Hewitt
Director, Portfolio Manager, Multi Asset Solutions
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Risk Disclaimer

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Views and opinions expressed by individual authors do not necessarily represent those of Columbia Threadneedle Investments.

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