The biggest threat to investors from high inflation is that equity valuations could fall as central bankers raise rates – because we discount tomorrow’s earnings into today’s price in part by using the prevailing interest rate. But market expectations are already for very high rates. It’s also not so much the policy rate as it is long-term bond yields that matter for equity valuations – that’s what’s actually used to discount earnings. They have already risen, and while our analysis suggests they may have a little more to go, we note they have already risen by close to the average amount they have risen ahead of, and during, the last four periods of rising policy rates.
The best-performing parts of the market last year were a mix of both profitable technology companies – which have strong pricing power and inflation resilient earnings – together with financials and energy firms on cheaper valuations, which benefit from the current economic environment. We think the rest of 2022 will be characterised similarly – a nuanced market with parts of both growth and value segments doing well.
If inflation does fall back more rapidly than expected while central banks have induced tighter financial conditions, we may need to become more defensive later in the year, but for now we think it’s a good environment for active equity investors.
Finally, balanced investors will need to ensure that they employ other sources of diversification than bonds. We do not think the role of bonds in portfolios is defunct. This view has been shouted many times over the last decade and even where rates have been negative, bonds have still helped during growth scares. However, because their potency is not what it was, and because equity market sell-offs may be driven increasingly by reactions to rising bond yields, other diversifying strategies might help.
