At the beginning of the calendar year we reiterated our view that 2022 would not be a repeat of 2021.
With the devastating war in the Ukraine and the focus on inflation and interest rates in January of this year, markets have not only experienced downside but uncertainty and volatility.
Markets dislike uncertainty and what the conflict creates is exactly that, hence the volatility.
Whilst sanctions have been both prompt and severe, it is Europe where we have seen the greatest volatility in equity markets.
Capital Economics in London put this into perspective, “the rest of the world’s direct financial exposure to Russia has fallen in recent years and, in aggregate, is now small. This limits the risk of financial contagion from the collapse in Russia’s economy that is underway. If financial contagion does spread to major economies, it is likely to be because losses are concentrated in a systemically important institution. The vulnerabilities are impossible to fully assess in advance of problems emerging but are likely to be greatest in Europe.
Whilst things can get worse from here as Central Banks look to lift interest rates, when looking at the selloff starting with inflationary fears, followed by the conflict and the ongoing shocks to supply lines, energy prices and commodity prices, a lot of negative news is priced in, and whilst we are looking at interest rate rises they will still be at historically low levels.
We have talked a lot about diversification and sources of returns, and we do believe excess returns for 2022 will come from both avoiding mistakes and from a variety of asset classes, as opposed to the dominance of returns from listed asset classes as these remain volatile however, the drivers of returns in an increasing interest rate environment will provide opportunity that comes from the pessimism markets are experiencing. For listed markets they need certainty.
As we go into the second quarter of 2022 our asset allocation is as reflected in the table below.
The underlying theme during quarter one 2022 was volatility and it returned in a meaningful way, with the broad US market, as measured by the S&P500, recording a correction and falling approximately 13% at its worst point in March before recovering some of these losses later in the quarter. The technology heavy Nasdaq composite briefly entered bare market territory with peak to trough falls exceeding 20% during the quarter, before again rebounding later in the quarter. These moves came following higher and more persistent inflation concerns at the beginning of the quarter, which were amplified by the terrible news of war in Europe. As we discussed above, markets gained towards the end of the month on the assumption that so much negative news had already been priced in. Some commentators added that hawkish language from the Fed on tackling inflation was also positive, however the risk of the Fed needing to go harder and faster than previously thought raises the probability of equity drawdown risks.
The Australian dollar detracted from unhedged global equities during the quarter as it increased through 75 US cents towards the end of the quarter on the back of strong commodity prices.
We moved all listed equity positions back to neutral around the middle of the quarter and then moved marginally overweight domestic and emerging market equities towards the end of quarter due to relatively more positive policy settings and a favourable market composition domestically, where overweights in materials and underweights in growth names should benefit our local market in a higher rate environment. These overweights were funded via a reduction in developed market equities, in particular US equities. We remain neutral listed equity markets in aggregate.
We assessed several direct property deals during the quarter, however we did not participate in any transactions, as higher valuations are making it more difficult to identify value acquisitions. The strong cap rate compression from late 2020 and 2021 looks to have eased, as tighter financial conditions dampen investor appetite for long duration property assets.
We remain neutral property and will be focusing on each manager’s ability to raise rents moving forward, as higher yields are necessary in many cases to justify the higher valuations in the market currently. Real yields for REITs still appear attractive on relative terms to bonds and they will be supported by economic growth and the longer term low absolute level of real yields. We remain neutral property as we enter quarter two.
The US Federal Reserve (“Fed”) raised their cash rate target by 25bpt to a range of 0.25 to 0.5% in March, marking their first increase in over three years. Interest rate expectations were volatile during the quarter having dropped in late February at the onset of war in Europe and then rising sharply in late March, with some commentators calling for consecutive 50bpt rises and total hikes exceeding 200bpt by the end of 2022.
Global government and corporate debt sold off aggressively during the quarter and recorded their biggest decline from a peak on record, falling 11% from highs reached in January 2021. We have remained disciplined with respect to our zero duration positioning within portfolios and this has provided strong attribution during quarter one. We note several managers we use have started to add duration to their portfolios for the first time in several years.
Domestic fixed income markets are pricing in over rate hikes by the end of 2022 and bond markets have responded in force, with the 10-year Australian Bond yield closing in on 3% near the end of March. Capital Economics have pointed out that “property remains the weak link as interest rates rise” and they have highlighted the sensitivity of property markets in regions such as Australia to increases in interest rates, noting strong linkages to consumption via wealth effects and structurally higher dependence on variable rate mortgages.
Short duration secure debt and cash positions were beneficiaries of our reduction in listed equity positions during the quarter and we enter quarter two with a marginal underweight position in secure debt, continuing to favour low duration managers and a neutral cash position.
Strong deployment from private credit managers during the quarter on the back of increased demand has seen returns from this part of the market increase for the first time in several years. Higher input costs are weighing on margins in the construction industry, and we remain cautiously positioned in senior secured loans as we view the likelihood of further stress in the building industry as likely following the collapse of high-profile building groups such as Probuild and Condev.
We participated in a domestic private market distressed credit strategy during the quarter, as we aim to further diversify return drivers and provide asymmetric risk opportunities that are less correlated to traditional markets.
Our underweight position in listed credit markets supported portfolios during quarter one, as historically tight credit spreads and global high yield spreads increased with the lift in implied recession risk. We remain underweight listed credit as we enter quarter two.
The unlisted nature of Private Equity and Unlisted Infrastructure has shielded performance during a volatile period. Infrastructure has continued to display its strong inflation hedging characteristics, with core allocations benefiting from strong demand in areas such as energy.
We expect the IPO market to continue to remain weak, as it tends to do during periods of heightened volatility, and we are monitoring the impact this has on the ability of Private Equity managers to exit positions.
We are seeing markets influenced by multiple events with a wide range of potential outcomes. This uncertainty can create opportunity as the drivers of returns will change with the changing environment. Tactical asset allocation will be important to take advantage of any dislocation. We continue to favour a diversified approach to protect portfolios in this environment.