Maintaining a defensive stance on equities

The current market environment poses a challenge to investors that stands apart from other periods of financial stress and economic uncertainty we have seen since the start of this millennium, if not longer.

Global equity markets are now undeniably in bear market territory, having fallen more than 20% in US dollar terms since the start of the year (sterling-based investors have fared somewhat better thanks to the weakness of the pound, with global equities down 9.8% in GBP terms). At the same time, global economic growth is slowing as China’s restrictive Covid policies and elevated inflation, largely a result of the ongoing Russia-Ukraine conflict, take their toll.

Ordinarily, we might expect central banks to cut interest rates to support financial stability and mitigate the impact of slowing growth. However, today the market is anticipating that interest rates will be around 3% higher in the US and 2.3% higher in the UK a year from now¹. The reason for this is inflation which is both elevated and proving to be stubbornly persistent.

Simplistically, most central banks have a dual purpose of maintaining positive economic growth whilst managing inflation levels. The main tool they have at their disposal to control inflation is interest rates. Theoretically, when rates are high there is a greater incentive to save money rather than spend it, demand falls and prices adjust accordingly, cooling inflationary pressure.

With inflation in both the US and UK at 40-year highs, and interest rates still at low levels despite recent moves, the expectation is that central banks will need to raise rates further and faster than previously anticipated to bring inflation back under control. This was demonstrated by the Federal Reserve’s decision to raise US interest rates by 0.75% at its June meeting, the largest increase since 1994. 

It has been a long time since a market sell-off has been met with higher interest rates. Central banks are unlikely to provide the "safety net" which investors have grown accustomed to and it is this uncertainty which has been driving the high levels of volatility we have seen recently.

What next for equity markets?

An important question for equity market investors is to what degree has all this been priced in? Having reached elevated levels at the start of last year, as a multiple of expected earnings, the MSCI All Country World Index has now returned to around long-term average valuation levels.

MSCI ACWI Index 12m forward P/E multiple

^{Source: Cazenove Capital, Bloomberg} 
Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This suggests that to a degree higher interest rates have been factored in and, while global equity markets don’t yet look cheap, there is greater valuation support.

The bigger question at this stage is whether earnings can continue to grow to support current market levels. Against a backdrop of high inflation and slowing economic growth (a “stagflationary” environment) corporate earnings might come under increasing pressure as consumers cut back on spending. If we start to see earnings expectations fall, there is the potential for share prices to fall further from here.

How much further could equity markets fall? Schroders’ strategy team recently noted that there have been 17 bear, or near-bear markets, since World War II. The average drop in the S&P500 was just over 28% and lasted nearly a year. If the economy enters a recession, bear markets have been more severe, with the S&P500 experiencing an average decline of nearly 35% lasting nearly 15 months. Should the economy avoid this outcome, the bear market bottoms out at around 24%, with the sell-off lasting just under seven months on average.

What does this mean for our strategy?

So far this year, we have focused on increasing the quality and defensiveness of our equity holdings. We have tilted portfolios towards businesses with strong balance sheets and the ability to defend margins by passing on higher costs to their customers. This has helped us to navigate the volatility of recent months and we continue to believe that these higher-quality companies will be better placed in a more challenging economic backdrop.

We are conscious that we are moving into an environment where economic growth is slowing and the probability of a global recession within the next 12 to 18 months has increased. Historically, equity markets have underperformed in these periods. Having reduced our overweight exposure to equities in the first quarter, it may be prudent over the medium term to look for further opportunities to moderate our equity allocation.

Annualised returns (excess of cash), % since 1970

^{Source: Cazenove Capital, Refinitiv Datastream} 
Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

Outside of equity, over the past year we have increased exposure to alternative assets including absolute return funds and commodities. Along with more defensive assets such as gold, these asset classes are well placed to deliver meaningful diversification and help defend capital in volatile market conditions.

We remain underweight fixed income for now. While government bonds are looking better valued after a notable sell off this year, we are conscious that rising interest rates will continue to pose a headwind to capital values. Within our fixed income holdings, we have greater exposure to shorter-dated bonds which are less sensitive to rising interest rates. Over the medium term, we may look to increase our allocation to bonds to provide more protection against an economic contraction.

¹ Data as at 15th June 2022