Investor Insight 105, January 2022

THE YEAR AHEAD

Last month we published the ‘Hamilton Wealth Partners, Investor Insight 104, the year that was’, reflecting on what shaped 2021, and whilst we were looking for equity markets to be strong, their overall strength surprised us. This month we publish our outlook for the year ahead.

At the start of 2021 we believed the key theme would be the year where we see the world bounce back economically from the global pandemic. This proved to be the case, surging GDP growth underpinning equity markets.

To put this GDP growth in perspective, the IMF measured contraction during 2020 of -4.9 per cent, and projects growth globally in 2021 at 6.0 per cent and into 2022 above trend at 4.9 per cent.

We believe 2022 will be the year where investment portfolios will see the benefit of asset allocation and diversification.

When we look back at the end of 2022, we believe investors will be pleased they have been exposed to risk-based assets, however it is going to be a bumpy ride.

The debate that is being held is whether equity markets are overvalued and therefore the next correction is around the corner, or are we once again into the “roaring twenties”, with plenty of upside still to come? Our view is somewhere in the middle.

As we head into 2022, we are overweight risk-based assets (as per the table below), however this overweight position has been wound back over the last twelve months.

Inflation is an issue, looks as though it will be systemic, but mild and manageable if wage price inflation does not take hold.

Interest rates will trend higher but again at a manageable level, and well below trend on a long-term basis, therefore continuing the “lower for longer” theme.

Inflation and interest rate expectations must be watched carefully as they will indicate if we are to see rougher water ahead, but at the same time the headline watchers will take risk off the table at the slightest move which is why we are expecting higher volatility.

There is a lot of cash on the sidelines looking for a home. “TINA” (there is no alternative) is real, with USD2.7Tln of dry powder on the sidelines for private equity and venture capital alone. Asset price appreciation and strong economic activity will ensure that this cash will find its way to risk based assets, especially those that are liquid.

This is not a fundamental reason to support equities though. Heuristic Investment Systems, our asset allocation consultants, look at eight key criteria to assess equity drawdown risk and at this stage only one suggests a heightened risk of drawdown, namely valuations. The eight criteria are:

  1. US Yield curve
  2. US Unemployment Rate
  3. US Merger & Acquisition transactions values as a ratio to US Nominal GDP
  4. US Real GDP Output Gap
  5. Gap between the Real Fed funds rate and the US Neutral Fed Funds
  6. Valuations
  7. US Real Wages Growth
  8. Change in US Fed Funds rate

Based on fundamentals, equities are therefore fully priced but not overstretched.

The challenge for asset allocations is whether we have reached the peak in markets yet. While a degree of complacency has crept in, our key message is to be prepared for volatility.

As we enter 2022 our asset allocation is:

FIXED INCOME

We head into 2022 with the following fixed income overlay:

  • Negative (underweight) towards domestic exposure as well as Negative towards international
    exposure.
  • Neutral towards Investment Grade credit, which provides an attractive yield pickup over sovereign bonds with low default risk, and Neutral credit overall.

With the exception of China, all Central Banks are signalling higher interest rates to come in 2022. The timing and size of these rate rises will differ between countries and the markets will continue to second guess Central Bank moves. Capital Economics notes that the pace of tightening will likely be slower than markets currently anticipate, although not in the US.

Volatility is assured. Yield curves have flattened towards year end as the market has priced in higher short term interest rates, but the market may have priced in a faster pace of tightening than is warranted, particularly if growth stalls due to the spread of COVID variants. While nominal inflation will fall, core inflation will remain stubbornly high. Ten-year US Treasury Bonds are ending 2021 at 1.40% and ten-year Australian Treasury Bonds are ending 2021 at 1.60%. Expect to see these yields at or above 2% in 2022.

Tactical Asset Allocation: Quarter 4 2021

Asset ClassWeightLevel
Australian EquitiesNeutral
Developed Market EquitiesOverweightMarginal
Emerging Market EquitiesNeutral
Private Equity/Growth AltsOverweightMarginal
PropertyOverweightModerate
Diversified CreditUnderweightMarginal
InfrastructureNeutral
Secure DebtUnderweightMarginal
CashUnderweightMarginal
DefensiveAlternativesNeutral

There will be great opportunities for fixed income traders but, for investors, caution is warranted. Fixed income will not provide the defensive characteristics that many investors expect. Floating rate bonds and/or short duration fixed rate bonds continue to be preferred.

CURRENCY

Our regular readers will know that we are not comfortable forecasting a level for the Australian Dollar (AUD) as no one ever calls it correctly, but we are prepared to give a direction.
The AUD trended lower in the second half of this year, but we see it trending higher in 2022. The AUD is closing 2021 at around .7100 but we expect commodity prices to remain firm in 2022 and this should provide support, notwithstanding that short term interest rate differentials may favour the USD as they raise interest rates sooner and faster than Australia.

We remain 50% hedged for all client global equity allocations.

EQUITIES

We continue to advocate equities over fixed income when it comes to considering the potential
returns available from investing across asset classes. Earnings will improve over 2022, although at a slower rate than what we experienced in 2021, with the easy gains coming out of COVID now behind us.

Domestically, we see a dividend yield less the bond rate of just under 2 per cent (before franking).

These numbers are historically in line and illustrate why the sharemarket is seen as a destination for yield: equities also offer liquidity, which is an important consideration within portfolio construction.

Likewise, in the US market – where again these figures are not elevated – we see an equity risk
premium of about 5.5 per cent and a dividend yield less the bond rate of 0 per cent.
However, the US is a low-dividend market. There, about 65 per cent of the constituents of the S&P500 offer a dividend yield in excess of the US 10-year Treasury bond.

Market composition is the key: in Australia we have an index where financials and materials are overrepresented, and technology is under-represented, just to name three sectors.
The ASX200 simply does not reflect or represent the economy. Furthermore, many companies
including leaders like CSL, Macquarie Bank, ARB, James Hardie and Mainfreight derive much if not
most of their income internationally. In other words, they are more than domestic companies.
We enter 2022 with a marginal Positive or Overweight position towards Developed Market Equities,
favoring Developed Markets outside of the US and this is predicated on the back of stronger earnings revisions out of Europe. Australia remains Neutral as does Emerging Markets.
The biggest risk that we see to this view is a policy mistake from the US Federal Reserve, that being a scenario where they are ‘behind the curve’ and required to tighten more aggressively than anticipated because of high inflation at a time when the US economy is already slowing. This is not our base case scenario although it is a risk factor we are watching closely.

PROPERTY

We maintain a moderate Positive or Overweight property allocation, including REITs, as we enter
2022. Our conviction increased late in 2021 on similar grounds to that of equities, with REIT yields being more attractive in relative terms to the real yields on offer through bonds or credit. This overweight position has been expressed primarily through domestic REITs due to their highly liquid nature.

We have struggled to see value in direct property deals of late, after actively participating in several direct deals in late 2020 and early 2021. At a sub-asset class level, we have reduced our allocation to industrial assets, following one quick realisation of an industrial asset on the back of booming industrial valuations, and we have made allocations to newer sectors, such as build-to-rent – where it is appropriate for client portfolios.

Entry levels for property acquisitions during 2022 is going to be the key to realising value in the years that follow and although we hold an overweight or positive view of property for 2022, we remain squarely focused on ensuring we pay the right price for long term direct property.

ALTERNATIVE ASSETS

This is an asset class we have increased our focus on over the last couple of years. Allocations have been selectively increased over the last twelve months and we will do so again in 2022 for those portfolios whose allocations are not yet at a satisfactory level.

We need to ensure that sequencing risk is reduced by providing a spread of vintage during portfolio construction. We also have several investments in the harvest stage therefore both these occurrences will see us selectively look at new opportunities in the year ahead.

We need to ensure that risk within this asset class is managed with by ensuring diversification within sub-asset classes and amongst both assets and vintages.

We do believe our portfolios will continue to see strong returns from this part of the market in 2022 as assets continue to see positive evaluation.

Alternative assets reduced volatility and enhanced returns over 2020 and 2021, and we are very encouraged for what lies ahead for our portfolio exposures in 2022.

There is a clear benefit in looking at diversification, including private assets in the areas of Property, Diversified Credit, Private Equity and Infrastructure, where appropriate for a client’s risk appetite.

We have attempted to maximise Alternative strategies in client portfolios, and this has been a strong emphasis since mid-2018. Illiquidity can be an issue for some of these strategies but, provided the weighting is suitably conservative and in line with a client’s risk profile, these can also provide clients with attractive returns uncorrelated to traditional markets.

FINALLY

We have noticed that several commentators are predicting doom and gloom in 2022.

As a wealth manager we always concentrate on fundamentals. These don’t support the doom and gloom scenario, but we are born optimists!

The one thing we can predict with confidence is that our returns in 2022 will not match those of 2021.

Volatility will continue, but provided interest rate rises are gradual, economic growth will remain strong, supported by solid corporate earnings, falling unemployment and overall fundamentals. The upward price trend of risk assets will persist.

The historically low levels of interest rates today inevitably imply lower returns going forward but interest rates at historical lows have also exacerbated total equity returns in the short term.

We become anchored to the circumstances we are often in – or how the latest market performance affected us.

When we are in a boom time, we think it will last forever; likewise, a bust.

Growth is not only strong looking forward but above trend, and whilst we foresee inflation this will be at a manageable level.

We are looking at an equity market that reaches beyond our shores, with a composition that is not representative of our economy and a yield that will underpin this market in the medium term.

That’s the point of balance to bear in mind.

Some segments of equity markets do appear overvalued, but equities nevertheless represent clear
value over fixed income, especially on a yield perspective. In the 146-year history of the ASX, the market has risen 80.1 per cent of the time. Once in five years, on average, the market declines, there is an often-used quote: ‘‘Volatility is the price you pay for a seat at the table.”

Risk should therefore be rewarded medium term over defensive, but through a conservative lens as
opposed to high beta exposure.

Successful investors never forget risk as a key component of strategy and the need for prudent risk management. Looking towards 2022, we are attempting to expose portfolios to risk exposure upside through equities and alternative assets whilst balancing risk in portfolio construction.

At Hamilton Wealth Partners, we will always position client portfolios for a full market cycle and will not be distracted by short term “noise”. Underlying asset valuations and credit quality are important to consider but asset allocation is the key and investors who are bold when markets are out of line with valuations will achieve the best results. Therefore, the combination of manager selection combined with diversification through asset allocation, discipline and patience should ensure portfolio outperformance is delivered.

Please do not hesitate to contact us if you wish to discuss in further detail and we wish you all the best and success in your investment strategies for 2022.