Investors should invest for all eventualities, not just their ‘base case’, as concerns around inflation, central bank policy and the spread of Omicron make this a particularly challenging time in markets, according to Legal and General Investment Management’s Justin Onuekwusi.
The head of retail multi-asset funds said he had never experienced a time with so much uncertainty surrounding the short-term economic outlook, which has made it almost impossible to create a ‘base case’ – the scenario that is most likely to happen.
“Usually an economist can always say they have a reasonable amount of confidence in the growth rate over three or six months. They might not be able to tell you in two or three years’ time, but on the short term they typically have a decent amount of confidence,” he said.
“But in this environment, the economists are really uncertain, so as a fund manager the big challenge is how to navigate that.”
His three main areas of concern were Omicron – and how effective vaccines will be at curtailing the spread of the new variant – inflation – and whether this can lead to demand-side rises such as higher wages – and central bank policy mistakes.
The manager’s predicted base case is that the economy will go through growing pains, where supply disruptions persist for months, but that inflation will start to relieve some time next year; growth remains healthy; and central banks face a dilemma, with the Federal Reserve in the US among the first to raise rates.
In this environment, growth, inflation and stock markets will rise, although not too rapidly, while bond prices will trend lower.
“Over time, the likelihood that a base case is right is less than 40%, but we always put lots of weight on the base case. Given all of the uncertainty, we have to put even less weight on it,” said Onuekwusi.
“We have 30% on the base case and then the rest focused on all of these different scenarios that could occur. We are trying to make our portfolio robust against all of them.”
LGIM’s potential outcomes
Source: FE Analytics
Other possibilities include the ‘roaring 20s’ of high growth, low inflation and accommodative monetary support – a time when stocks would boom – and growflation, when a strong economic rise would encourage households to spend their savings – growth and inflation would rocket, central banks would tighten and stocks would rise while bonds plummeted.
Conversely, lowflation is similar to what we have experienced in the past decade, with healthy growth, but low inflation and loose monetary policy. Here stocks rise slowly but bonds ease back.
Cycle compression involves overheating inflation, which reduces the length of this cycle. After a fast rebound in growth, it decelerates quickly afterwards. Stocks and bonds would be broadly lower, but would not fall as fast as in the final outcome.
Finally, the worst outcome for markets would be a deflationary slump, which would see Covid spike as new variants were discovered, growth rebounding and then curtailing to lower growth, lower rates and lower inflation. Here bonds would rally but stocks would nosedive.
How can investors prepare?
Onuekwusi said one of the most important considerations for investors was to understand where we are in the economic cycle.
“Because of the uncertainty, we are not sure whether we are mid- or late-cycle. It is one of the two. But what we do know is that it makes sense to invest in risk assets, especially in late cycle, which is a better time to invest than mid-cycle, but there is always a worry of how long it will be until a recession,” he said.
“Our recession indicators suggest it is unlikely we will see a recession in 2022 and 2023 unless the Federal Reserve starts to raise rates aggressively. So we have a bias towards equities overall. Relative to bonds, the valuations look okay.”
However, a growing problem is the fear of concentration, as having too much exposure to the US was a “real challenge” to investors.
The US now accounts for 65% of global equities, up from 45% 10 years ago and the top five stocks in the world’s largest economy make up 25% of the S&P 500, up from 10% a decade ago.
“This is increasing stock concentration in the US and advisers are really concerned about it. It is driven by the uncertainty in the world today as drawdowns in the market are being led by these stocks, which will have an impact on indices that we have not seen before,” he said.
As such, the manager has been moving away from the US into other regions such as emerging markets, where the change in policy stance in China to be more supportive of the economy should drive returns and growth in 2022.
“Also, from a valuation perspective, emerging markets are unloved and people are generally underweight. That is a time to get in. Although firms have inferior earnings to developed companies, the pricing has gone so far that even if they live off their inferior earnings, they still look attractive,” he said.
“We are also negative on duration, so have taken our fixed income allocations down – particularly in developed markets. We see more downside for bonds than upside.”