By Erik Knutzen, chief investment officer – multi asset class at Neuberger Berman
Five Major Inflection Points
Monetary and fiscal policy are set to stop loosening and start tightening this year, after more than a decade of the authorities fighting the forces of disinflation and sluggish growth.
As a result, a greater volume of liquidity is planned to be withdrawn from financial markets, at a faster pace, than ever before.
The reason for this tightening is inflation: We believe inflation is likely to ease from its current rate, but persist at a structurally higher level than that experienced over the past 20 years.
There are a number of reasons why we anticipate persistent inflation, but one other major inflection point stands out: the transition from fossil fuels to renewables.
And finally, following 20 years as the biggest contributor to global growth, China, with its ageing and shrinking workforce, is now prioritising “common prosperity” with a managed long-term slowdown
Interest Rate Risk
We think strong corporate fundamentals make positive total returns possible for investors who assume credit risk rather than interest rate risk, and who balance coupon income with the flexibility to invest across credit sectors and trade tactically. But few would back fixed income to lead the pack this year: Rising rates pose the most risk to bonds; government bonds have been the chief beneficiary of the central bank liquidity that is about to be withdrawn from markets; and inflation erodes the real return of fixed income assets.
While fundamentals remain positive, three years of exceptionally strong performance has left us with stretched index valuations. Moreover, many benchmarks have become dominated by growth stocks, which are expensive and sensitive to rising rates. We think value stocks, cyclical companies, smaller companies and non-US developed markets offer more direct exposure to the ongoing reflationary environment, at more attractive valuations, and with lower exposure to rising rates.
Not a 60/40 Environment
What to make of the big jump for commodities?
That fits with our view of how important diversification is likely to be in 2022. The challenge is that the traditional, bonds-versus-equities approach may no longer work, given the high valuations and interest-rate sensitivity in both asset classes.
Among alternative diversifiers, we think there is a special place for inflation-sensitive assets such as commodities and real estate, given the underlying economic dynamics. Commodities could offer potential inflation exposure and diversification at a time when bonds are too expensive, too sensitive to rising rates and too highly correlated with equities to perform that role.
Uncorrelated liquid alternative strategies may help, too, as well as equity index put-writing, which has tended to benefit from historical periods of volatility and offer a slightly smoother exposure to equity risk. Private equity and debt offer ways to generate potential returns away from the volatility of the public markets.
On the Same Page
We think that risky assets like equities are the place to be, given the fundamentally strong economy—but high valuations and the prospect of rising rates, less liquidity and more volatility make us more cautious than a year ago. Risk management is high on the agenda. We value genuine diversification, as well as flexibility and the capacity to stay nimble amid the potential volatility, and we recognise that inflation is likely to be the key risk to manage in 2022.