Genuine inflection points in markets come to pass relatively infrequently, yet Chris Metcalfe, chief investment officer at Iboss Asset Management, believes two have occurred since the end of November, enhancing the case for diversification.
The two dates to keep in mind are 30 November 2021 and 15 March 2022. On 30 November, Jerome Powell, US Fed chair, stated it was time to retire the word “transitory” in relation to inflation.
Ever since then, equities and bonds have pretty much fallen in tandem, which Metcalfe believes not only raises question marks about the old 60/40 equity/bond portfolios, but also means diversification is going to be more important than ever for asset allocators.
Meanwhile, after Chinese equities underperformed and lost over 50% of their value during one year to mid-March, according to Metcalfe, investors will look back on 15 March 2022 as a significant inflection point for the sector.
“The straw that broke the camel’s back was JP Morgan’s statement – supposedly published in error – on 14 March that Chinese tech had become ‘uninvestable’, which prompted a significant sell-off in Asian and emerging markets,” he says.
“A day later, however, in a situation entirely different from that of the developed world, the Chinese government expressed its desire to be more supportive of its stock market and this has resulted in Chinese equities rising 15% from their lows.”
Game changer
As a result, after a decade-long bull market for equities, Metcalfe says these two inflection points will mean people have to change how they think about their asset allocation. Approaches that worked well up until the end of November – namely a concentrated focus on growth, US and tech assets – must be replaced with something more diverse.
“What worked best in markets for more than a decade will almost certainly not work best in the next few years,” he says. “The strongest-performing areas since Powell’s speech – and going into a rising interest rate and inflationary environment – are those that were previously punished.”
The reason for the new paradigm, explains Metcalfe, is that with inflation in the US at all-time highs, bond markets falling, and growth and technology selling off owing to interest rate rise expectations, Powell does not have the ability to ‘pivot’ in order to calm down the markets as he did at the end of 2018.
“Post the ‘transitory speech’, there has been an incredible divergence between the funds we hold,” he says. “Across all the sectors, the best-performers up until December 2021 are the now the laggards in the new world, and the new winners are commodities, gold and global dividend-paying stocks.”
At the same time, as global inflation continues to surge, Metcalfe adds that investors could do worse than look to China as the ultimate way of providing an element of inflation protection.
“While many column inches are currently dedicated to the best assets to protect against inflation, our view is that it’s not just about selecting funds that move alongside inflation but picking assets that could outperform inflation,” he says.
“When considering fund and sector allocation, it is, in our opinion, an error to look at what worked successfully or unsuccessfully up until 15 March,” he adds. “This is because, over six months to the date in question, China, within the Asia sector, is generally 100th percentile; post-15 March, it’s third percentile. The game has changed.”
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Diversification rewarded
As a result, within its model portfolios Iboss recently reduced exposure to the Baillie Gifford Emerging Markets Growth Fund, favouring the FSSA Greater China Fund instead.
Alongside China, Metcalfe is also finding opportunities in alternative assets as a way of diversifying exposure to equities and bonds.
“Inflation will continue to make real assets – such as precious metals, commodities, real estate, land, equipment and natural resources – good sources of diversification from bonds and stocks,” he says.
Making up a combined 6% weighting within the model portfolios are property and infrastructure, and Metcalfe says this exposure has been increasing.
“We expect to maintain this allocation and it has helped us diversify over the past six to eight months,” he adds.
“However, it is important to note there is a big difference in the make-up of the underlying funds in their respective peer groups, so this is not just a case of buying the index.
“We hold two very different infrastructure funds, so again we are being rewarded for diversification.”
In addition to using real asset funds, Metcalfe says absolute return funds may also provide non-correlated returns, while he adds that income stocks offer the chance to outperform inflation.
“I don’t think many people expect global equity income to outperform inflation, but I believe you can include income assets as real assets in a world in which speculative technology and lots of other companies are making no money,” he says.
“We don’t expect income stocks to outperform inflation in the immediate term but, over the longer term, because valuations are lower and they are generating real cashflows, they provide asset protection.”
See also: Rush to real assets to fight inflation should be tempered with caution
But what of the bond conundrum? According to FE Analytics, the IA Global sector has fallen 12.5% year to date, while the IA UK Gilts sector is down by a similar margin, -10.56%.
“All fixed income has produced negative returns since Powell’s announcement and the first quarter of 2022 was the worst period for bonds in history,” says Metcalfe. “We are now approaching the midway point of the year and 2022 is just the second year in two decades that bonds and equities have fallen simultaneously.”
In terms of their positioning, Metcalfe says Iboss’ fixed income holdings are generally low duration, while it is also overweight high-quality corporate bonds and cash and underweight high yield.
“This has held us in good stead over the period and contributed to relative outperformance in our lower-risk portfolios,” he says. “At some point, fixed income will offer better value, but this is still some way down the road.”
To help with decision-making, Metcalfe does have a decent holding in strategic bond funds, and in the next quarter the team will be discussing if it is the right time to be easing more into some longer-dated assets.
“The fixed income landscape is changing rapidly, and we will have to change with it,” he says.
Returning to equities, while underweight US equites and growth, Metcalfe is seeing valuation opportunities within Europe and emerging markets, and remains overweight the UK.
“Any allocation to growth, irrespective of region, has been a negative contributor to relative and total returns, and any allocation to value – excluding emerging markets – has been a positive contributor to total returns,” he says.
“So, style has been much more important than overall regional allocation,” he adds. “The only stand-out from a regional view has been emerging markets, which shows the weight of negative sentiment there right now. Meanwhile, UK equities have hugely outperformed in value and even demonstrated some relative outperformance from a relative growth perspective.”
The new rules
Given how much has changed in the past six months, asset allocators will have little choice but to do things differently going forward. “It is no longer about just looking at equities, bonds or geographies,” Metcalfe says. “It is about which fixed income assets you hold, which geography you invest in and which investment style you use, namely growth, value or a blend.
“The same tailwinds that have driven every asset upwards for a number of years are now headwinds, and this will require a change in mindset and the need for greater diversification,” he adds.
“For the past few years, it has often been relatively easy for clients to use stock momentum to make significant gains in global markets and often without the aid of an adviser.”
However, in this new investment world he calls “post-transitory”, Metcalfe argues the coming months and years will provide a significant opportunity for advisers to demonstrate the value of their advice.
“Nothing is ever certain in investing, but it feels like the era of rear-view mirror investing is over and that a more considered approach, reliant on old-fashioned values such as profit and a good business model, will come back to the fore. In this new model a genuine diversification of assets will be rewarded.”
BIOGRAPHY
Chris Metcalfe entered the financial services industry straight from school at the age of 17, joining Prudential in 1982. He went on to spend 16 years at the insurer before moving over to RJ Temple in 1998, and then founding his own IFA business, RMB Financial Management, the following year. After switching firms to join Harrogate Independent Financial Solutions in 2001, Metcalfe set about putting a range of model portfolios together. He co-founded Iboss in 2008 and has developed its investment process over many years.
This article first appeared in the June edition of Portfolio Adviser Magazine
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