The risk of a correction is rising
Inflation has moderated in the second half of the year – but it may be more of a threat in 2022.
It has been almost a year since news of a successful vaccine against Covid-19. In that time, the MSCI World Index has risen some 20% while any dips have been shallow and short-lived.
Investors' enthusiasm won’t last forever. However, for now, we are sticking with our overweight allocation to equities. The key reason is that both GDP and corporate earnings should continue to grow, providing fundamental support for the asset class. After a dramatic rebound in earnings this year, companies are on track for a year of solid, if unexciting, earnings growth in 2022. We also continue to see pockets of value within stock markets, as well as compelling growth opportunities.
A foot in both the growth and value camps
The strong recovery from the pandemic paved the way for a dramatic comeback for more cyclical sectors, after years in the doldrums. However, over recent months it is growth sectors that have once again taken the lead. This has rewarded our decision to maintain our overweight allocation to technology and healthcare, which we think continue to offer a multi-year opportunity. We also maintain our carefully selected exposure to more cyclical sectors.
These should start to perform more strongly as fears over the delta variant subside. In case this takes time to materialise, we have tilted our exposure towards higher quality companies with healthy balance sheets.
Rising risks of pullbacks
The early months of an economic recovery tend to be the best for equity markets: the transition to a period of lower growth can be tricky, as investors question the strength and durability of the expansion. Equities can continue to deliver attractive returns, but the path tends to be bumpier. We may well be entering such a phase now and we are therefore maintaining our exposure to defensive and diversifying assets. These can help protect portfolios during equity market drawdowns and reduce overall volatility.
Lower returns as economy transitions to next stage
S&P500, average cumulative return (%) in different phases of market cycle
Source: Goldman Sachs. Returns from S&P500 since 1973. The “hope” phase of the market cycle typically starts in recession, as investors anticipate economic recovery.
Inflation makes diversification trickier
The prospect of inflation closer to 3% rather than 2% could create a more challenging environment for conventional government bonds – traditionally the key defensive asset within portfolios. We have therefore reduced our position in conventional bonds in favour of inflation-linked bonds, which have defensive characteristics while also offering inflation protection. We have raised our exposure to high-quality credit as a way to enhance returns from our defensive assets without significantly increasing risk. Lastly, we have slightly increased our allocation to hedge funds. We are focused on funds that can generate attractive returns with low correlation to equity and bond markets.
Issued in the Channel Islands by Cazenove Capital which is part of the Schroders Group and is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. 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 document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.