Two years on and Covid is still very much present in the minds of investors as we head into 2022, but potential lockdowns are by no means the only risk to markets, as inflation and rising interest rates are also on the cards for next year.
With that in mind, Trustnet asked several market commentators which parts of the market they would avoid to mitigate the risks.
The least popular asset class with experts was fixed income, which Ben Yearsley, co-founder of Fairview Investing, said looked “unexciting to say the least.”
Despite the Omicron variant causing a “quasi lockdown” in the UK and full lockdowns elsewhere, Yearsley said that growth was still strong and inflation “more persistent than many thought”, which meant that bigger interest rate hikes were more likely, none of which favours bonds.
“I might stretch to high yield being okay,” Yearsley said. “I know government bonds do still act as a safety net and diversifier, but the returns aren’t looking great.”
Some were even more disparaging about the potential returns on bonds next year.
Gill Hutchison, research director at The Adviser Centre, said that there is “virtually no scope for capital gain from core government bonds and higher-quality corporate bonds”, adding that coupon returns would be the “most optimistic scenario”.
Although 2022 is likely to be a challenging year for other asset classes, Hutchison said that fixed income is likely to struggle the most.
“Nominal government bond yields remain very low by historic standards and, given higher inflation rates, real yields are in deeply negative territory,” she said.
Persistent and rising inflation is the big case against bonds as the two have an inverse relationship. Typically bonds pay a fixed level of interest and if inflation rises beyond central bank’s targets, they usually increase interest rates as a way to control it. This erodes the value of the future interest payments a bond will make, as well as the total amount of return an investor makes when the bond matures.
Inflation rose to the highest levels in a decade in the UK during November, hitting 5.1% and went even higher in the US, reaching 6.8%. This was far above the 2% target and consequentially the Bank of England recently announced it raised interest rates for the first time in three years, moving from 0.1% to 0.25%.
Although it is not a massive jump the increase does demonstrate some intent from the central bank to act further if inflation does not settle, and would make more changes in the new year less jarring for investors.
But Darius McDermott, managing director of FundCalibre, is worried that “central banks will mess things up”.
“As Jim Leaviss, manager of M&G Global Macro Bond, pointed out to me recently, raising interest rates won’t help supply chain blockages – which are what is driving inflation now in my view,” McDermott said.
Although there has been some wage inflation, many companies are still recovering from the impact of Covid lockdowns and would struggle to raise wages in tandem, McDermott said.
“I think central banks will get nervous and raise rates nevertheless and this could possibly knock us into recession,” McDermott said.
“So, for me, fixed income is to be avoided in 2022 – possibly with the exception of high yield which could at least give a small but positive real return.”
Outside of fixed income, several experts were particularly bearish on US equities, the powerhouse behind global markets’ returns in recent years.
Compared to any other market, the S&P 500 has made the highest returns over one, three, five and 10 years, making 336.8% during the latter.
Performance of indices over 10yrs
Source: FE Analytics
These high returns have been down to some extremely profitable and fast-growing companies such as Amazon, Tesla, Apple and Alphabet. But a consequence of this has been increasingly elevated valuations, particularly in the technology and internet sectors.
For some, these record high valuations are justified, given the sizeable returns generated, but according to Hutchison the US is “egregiously priced”.
The last time US valuations, and tech stocks specifically, accelerated astronomically was in the 1990s when the tech bubble occurred “and we know how that ended,” she said.
Emma Wall, head of investment analysis at Hargreaves Lansdown, was also sceptical about US stocks, calling them “too toppy”.
“I would instead focus on undervalued and unloved areas, such as the UK equities and Japan,” Wall added.
Going against the grain, Andy Merricks, commentator and manager of the 8AM Focussed fund, said that he will not be rushing to buy anything with sustainable or the environmental, social and governance (ESG) acronym in the title.
“Let me stress that this is not because I am opposed to the principles lying behind either movement – no fair-minded person would be – but everyone is talking about it and launching products in the sphere and when everyone is doing the same thing it is often the time to look elsewhere,” Merricks said.
ESG investing gained a lot of attention in 2021 after COP26 put pressure on governments to tackle climate change and European regulators enforced more rules around labelling funds as sustainable.
Investors have responded with increasingly high inflows into this part of the market, particularly the equity options. Calastone’s latest Fund Flows Index reported that it was “due to the incredible and undiminished success of ESG funds”, that equity markets had any inflows in November, with sustainable funds taking in a record-breaking £1.5bn.
The report found that equity funds with no ESG mandate suffered outflows of £1bn for the second month in a row. Indeed, November was one of the worst months Calastone has seen for non-ESG funds.
This pattern of high inflows into ESG focused funds may be well-intentioned but many asset managers have been on a mission to rebrand existing products or launch loosely, ESG-applicable options to capture these inflows. This is the issue Merricks is trying to avoid.
“I feel that there is a risk that with so much cash chasing the same names, and with many of these names being small- or mid-cap companies, a bubble could be inflated,” he said.
“It’s becoming corporate suicide not to talk the talk on ESG.”
Merricks added: “ESG and sustainability are perfectly sensible and virtuous concepts, but when everyone is saying and doing the same thing the investment opportunity is diluted. Personally I think that it will be better to be more sector-specific within the myriad of options available.”