Multi-Asset Income: Staying the Course

What we learnt from 2021 and what we expect in 2022

• The start of a new year is an opportune time to reflect on what the markets taught us last year and how we can apply that to the coming year.
• 2021 was a year where we were broadly rewarded for positioning our Income Allocation portfolio to participate in global recovery and reflation (via equities) while maintaining adequate diversification (via government bonds).
• Looking to the coming year, we remain positive but anticipate more volatility and dispersion in markets. As such, we have positioned the portfolio ready to be tactical when the time is right

The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise. There is no guarantee that the fund will achieve its objective and you may get back less than you originally invested.

Staying the course in 2021

The major benefit of a broad tactical multi-asset mandate is the ability to change one’s mind when markets change. However, sometimes ‘staying the course’ and not making unnecessary short-term portfolio changes requires just as much active decision making and portfolio discipline as trading more dynamically. In our opinion, there is a time and place for both.

As active managers, we continually reassess and re-underwrite our positions as markets move. ‘Are those positions that have rallied strongly now more expensive and thus less attractive?’ ‘Are areas of the market that have sold off offering potential outperformance or diversification benefits?’

Overall, 2021 was unequivocally a ‘risk-on’ year – investors were rewarded for staying long in a global recovery. However, relying on the headline index performance numbers alone could lead a casual observer to thinking that 2021 was a boring year for markets. Far from it!

Figure 1: 2021 Cross asset total returns

Source: Bloomberg, 31 December 2021

For 2021, our ‘participate but diversify’ positioning meant actively managing the balance between participating in global economy recovery but accepting there would be setbacks and reversals in risk appetite along the way.

Participating in global recovery

Equities were the key portfolio return driver for the year (see Figure 1). Broadly, equities were supported by global growth beating already high expectations as mass vaccinations and increasingly adaptive economies reduced the sensitivity of economic growth to the virus, helping fuel exceptionally strong corporate earnings.

We chose to express this recovery and reflation narrative through exposure to bank equities. Over the year, the S&P 500 banks gained +29% (in USD) and the EuroStoxx banks index gained +42% (in EUR). However, this wasn’t a smooth ride. A key feature of the equity markets in 2021, was significant rotations from sectors that could be considered long duration (most notably large-cap growth equities such as tech) towards beneficiaries of higher rates (in other words, banks). 

In hindsight there are several other ways investors could have chosen to play this theme ‒ for example, oil and thus energy equities were supported by increased demand from a rise in global mobility and constrained supply. Indeed, WTI (reflecting the price of crude oil) gained +59%, capping its largest annual gain since the 2009 recovery from the Global Financial Crisis, while the MSCI World Energy index gained +42%. However, our preference for banks was not only that they offered attractive fundamentals (having successfully weathered the potential storm of COVID-related delinquencies) and that valuations remained attractive relative to the market but also, importantly, that banks offered an attractive return profile in the face of higher rates and a steeper yield curve.

Figure 2: S&P 500 Banks and NASDAQ Cumulative YTD Returns versus US 30-yr Treasury Yield

Source: Bloomberg, 10th January 2022

Actively seeking portfolio diversification

In 2021, as an investment team, we probably spent more of our time debating US government bonds in the face of changing growth/inflation/policy market narratives than any other topic. Our positive view on US 30-year Treasuries was arguably our most out -of-consensus view of 2021. However, it’s important to place it in the appropriate portfolio context.

First, given we can’t predict the future, we seek to construct a portfolio for a range of outcomes that may not be priced into the current consensus view of the world. These can be alpha opportunities to generate return or, as with US 30s, diversification opportunities to manage risk.

Second, the position should be directly considered in conjunction with our banks exposure and could be thought of as an insurance against virus/reopening/growth set-backs that could have ignited a ‘risk-off’ correction and flight to quality.

Thus, while holding US duration was a net detractor for the whole year, it played an important role managing portfolio risk during rotations in the equity market and again late in the year when the emergence of the Omicron variant of COVID-19 (briefly) caused a re-evaluation of global growth prospects – a risk that, at the time, had largely drifted from the minds of most market participants.

Emerging markets

Inflation and central bank policy also weighed on emerging market government bonds over the course of the year. Emerging market local currency debt has always been an important part of our broad multi-asset income investment universe based on the belief that, over the medium- to long term, attractive yields on offer more than compensate for shorter term spot foreign exchange volatility. However, the asset class as a whole faced headwinds last year from both rising rates (as emerging market central banks hiked interest rates to fight inflation) and depreciating currencies (as US policy turned more hawkish) (see Figure 3).

Today, we continue to find select emerging market local currency bonds attractive, given that growth remains robust and local inflation could moderate in 2022 in light of 2021’s hiking cycles. Against this backdrop, valuations appear reasonable to us, yields look attractive versus developed markets, and sentiment is potentially over-bearish.

Further, we would note that in the prior US tightening cycle, emerging market local currency debt experienced headwinds in 2013-2015 as tapering occurred but returned to positive performance once the rate hiking cycle began.

As in any year, 2021 also saw us evaluate and pass on a number of investment ideas. China was the most pronounced example. Our ‘Episode’ philosophy, which informs the approach taking to run the Income Allocation strategy, provides a clear framework for assessing whether market prices have diverged from fundamentals. In our opinion, the sell-off that occurred in Chinese equities in July didn’t fully fulfil all the criteria of an ‘Episode’, in that although there was material price action, the moves appeared to be a relatively rational re-pricing of the outlook, given the extent of China’s regulatory re-set and new priorities aligned with China’s ‘Common Prosperity’ drive to narrow the country’s wealth gap.

Figure 3: EM Local Currency Bond Index Performance versus US interest rates

Source: Bloomberg, 10th January 2022

Looking to 2022

The consensus now appears to be a US Federal Reserve that will move swiftly from ending tapering in March to raising interest rates, given an increasingly politicised concern over inflation; a consensus that Omicron cases will peak in the first quarter in the western world and that growth will be lower than 2021 but remain robust and above trend. However, given its zero-COVID strategy, Chinese economic activity could be more sensitive to Omicron-led shutdowns. As a result, continued negative real rates support equity ownership over fixed income with an expectation that, given the respective starting points, market-led returns could be lower but with more volatility (both absolute and dispersion between markets).

In this regard, the Income Allocation strategy remains positioned for ongoing global recovery (owning cyclical equities with an overweight to banks) but cautious of risks to that base case and thus both active in sourcing and tactically adjusting diversification (via bond positioning); picking up attractive yield where we can find it (emerging market bonds) and holding dry powder (cash) ready to buy when others are selling if there are ‘episodes’ in markets.

A final word

Thus, in 2021, we were broadly rewarded for positioning our Income Allocation portfolio to participate in global recovery. Over the year, the consensus largely converged to where our own views have been for a while; providing a tailwind for our own performance.

As we enter 2022, though the positioning of the Income Allocation strategy remains relatively unchanged, we are acutely aware that we must remain vigilant to changes in potential risk/reward as market pricing changes. As such, we anticipate a busy 2022 across markets and we will continually look for opportunities to lean against consensus where we believe the market may have got ahead of itself; either to add return or improve portfolio diversification.

Key risks associated with investing in this strategy

Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the strategy

The strategy is exposed to different currencies. Derivatives are used to minimise, but may not always eliminate, the impact of movements in currency exchange rates.

Investing in emerging markets involves a greater risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks, among other factors. There may be difficulties in buying, selling, safekeeping or valuing investments in such countries.

The strategy may use derivatives to profit from an expected rise or fall in the value of an asset. Should the asset's value vary in an unexpected way, the strategy may lose as much as or more than the amount invested.

Investments in assets from China are subject to changeable political, regulatory and economic conditions, which may cause difficulties when buying, selling or collecting income from these investments. In addition, such investments made via the 'Stock Connect' system or traded on the China Interbank Bond Market, may be more susceptible to clearing, settlement and counterparty risk. These factors could cause the strategy to incur a loss.