2022 Investment outlook

2022 Investment outlook

Therecentexplosionininflationhascaused investmentmarketstoturnfromwherethey were, in a growth mindset, to one where value shares are beginning to outperform. We have written extensively on this development over the past few years, warning that when markets turn it will be decisively in favour of cheaper, cyclical shares that benefit from inflation.

TheUSFederalReserveBank,theFed,had been saying for most of 2021 that it expected inflation to come under control quickly. Theinflationdataon10th February 2022showed7.5%annualisedinflation,the highest inflation rate since 1982. This has since risen to 8.3% in May.

This different outcome has caused concern at the Fed and a change in tack towards a faster rate of increase in interest rates. Market expectations are now of between 4 and 5 increases (of 0.5% each time) in U.S. interest rates in 2022, which is a rapid rate of tighteninggivenwhereinterestrateshave beenoverthepastfewdecades,butnowhere near as high as they were during the inflationaryperiodsinthe1970sand1980s.

US Fed Funds Interest Rates over 50 years

Graph source: Tradingeconomics.com

Theexpectedincreaseininterestratesisless severeintheUK,andtheBankof England’ s yield curve chart (see below) implies that interest rates will peak in just over a decade at about 2.4% (in February that figure was circa 2%):

However,thisisnotatruereflectionof what the real, or after inflation, yield is on UK governmentdebt(yield curve graphs source: Bank of England):

The graph shows that UK bonds are expected to have negative real returns of betw This een me mi ans nus that 3 i .5% and minus 1.0%. nvestors are expected to have lower returns than inflation, eroding the true value of the income and, importantly, the capital repaid at the maturity of the bond. We are of the view that this fundamental unattractiveness of owning government debt (US, UK or anywhere else in the developed world) will meaninvestorsabandongovernmentbonds in favour of equities or are prepared to acceptnegativereturnsontheirinvestments, with all the problems that would cause. We think the former is the base case for the

comingfewyears. Asaresult,weexpectthe yields on governmment debt to continue to rise until a prospect of a positive real yield is in sight. If central banks fail to raise rates due to concerns about a recession, then it is likely that the currency will weaken substantially. This is what is happening in the UK. Over the past month the pound has depreciated by about 6.7%, moving from $1.314 to $1.226,althoughitimprovedslightlyinlater May. This is causing imported price inflationthatispredictedtotakeinflationto over 10% in the second half of the year, according to the Bank of England.

GBP to USD exchange rate between 14/4/22 and 13/5/22

(Graph source: Yahoo finance)

We also believe that with higher interest rates, growth companies become less attractive as their future cash flows get valued at a lower amount due to the effect of higher discounting of those cash flows. This will reduce today ’ s valuations, and is one of the reasons that US tech stocks have had such a torrid time over the past year. The tech dominated Nasdaq market has fallen 25% this year (data as at 13th May 2022). In this new environment, we favour those companies that are able to push through higher prices and who are traditionally consideredtobenefitfrominflation,suchas tobacco companies and super markets. Commodity stocks should also benefit from higher prices. Theimportantquestionthatwealsohaveto ask is what the effect of the war in Ukraine going to have on the outlook for the world economy. Inthenextarticlewelookathow this is affecting our view of the investment environment in 2022.