Encouraging signs on Omicron

The Omicron variant has caused coronavirus cases to spike to their highest levels since the start of the pandemic in many countries. Thankfully, widespread vaccinations and the reduced virulence of Omicron mean that hospitalisations and deaths have not followed suit. The next few months are still likely to be difficult: given the scale of infection, there could well be pressure on hospital capacity even with a lower rate of serious cases. However, looking further ahead, Omicron could herald the end of the pandemic as coronavirus becomes more of an endemic disease and less of a burden to the world’s health systems. This possibility helped equity markets rally strongly into year end.

Fed set to follow BoE’s interest rate lead

Central banks had an unusually busy December. The Bank of England raised its Base Rate to 0.25%, from 0.1% previously. We expect it will follow up with another 0.25% rise in February and then pause as inflation starts to moderate from current high levels. US monetary policy appears to be on a similar path, with a lag of several months. In December, the Federal Reserve indicated it would end its asset purchase programme by March and raise interest rates by mid-year. We expect one further increase this year. Equities have largely shrugged off the prospect of higher interest rates, though it may be apparent in the weaker performance of sectors that are particularly sensitive to liquidity conditions - such as early-stage technology. China stands out as the only major central bank that is likely to ease monetary policy this year, as the country contends with a significant slowdown.

Geopolitical disputes back on the agenda

Long-running international tensions subsided somewhat as countries turned inwards to deal with the pandemic. However, as the health threat recedes, several key flashpoints are coming into focus again. Ukraine is currently of greatest concern, with a significant build-up of Russian troops at its border. Developments relating to Taiwan and Iran are also worrying. While full-scale military conflict is not currently the most likely outcome in any of these situations, there are many other scenarios that could threaten global growth – including sanctions, tariffs and disruptions to energy supply. More generally, relations between the US and China remain tense and could flare up again in 2022 – especially with the US facing mid-term elections later in the year.

Portfolio positioning

Within our multi-asset portfolios, we head into 2022 with an overweight position in equities relative to our strategic allocation. Our forecasts for economic and corporate earnings growth continue to suggest maintaining exposure to the asset class. Our portfolios stand to benefit from ongoing economic recovery, though we remain focused on longer-term themes such as energy transition, technology and healthcare. Away from equities, we have a preference for alternative investments over fixed income. We continue to expect bond yields to rise from current low levels as central banks raise policy interest rates and inflation remains higher than pre-pandemic levels.

Outlook

	Economics	Strong, but slower growth in the year ahead versus 2021 Growth supported by elevated consumer spending and increasing capex Economic activity data has peaked but remains elevated particularly in the service sector Inflation could remain elevated in the near term Moderating monetary and fiscal policy
	Valuations	Bonds remain expensive but can provide some defensive ballast Equities are expensive relative to their own history, but need to be supported by earnings growth Alternative assets including absolute return funds look relatively attractive as diversifiers
	Sentiment	Investors remain concerned about covid variants, persistently high inflation and threats to global growth Sentiment indicators have moderated from extended levels Volatility has picked up recently in response to Omicron concerns
	Risks	Risk of ‘stagflation’ i.e. slower growth, higher inflation Risk of Omicron variant and vaccine efficacy concerns Impact of slowing growth in China and potential for further regulatory intervention Elevated asset valuations Growing geopolitical tension (Ukraine, Taiwan, Middle East)

Asset Classes

Asset classes	Current positioning	Medium term view	Current views
Equities			Near-term sentiment has been impacted by Covid concerns with the spread of the Omicron variant, central banks’ reaction to high inflation figures, and concerns over Chinese growth centring around the growing property sector crisis. This could result in further periods of equity market volatility. Over the medium term the expectation for above-trend growth and robust earnings should support markets. We maintain conviction in long-term secular themes including technology and health care and energy transition.
Bonds			Longer-dated government bonds offer defensive characteristics given growth concerns. Valuations however remain expensive. We prefer USD and Chinese government bonds due to relatively higher yields and diversification benefits. We prefer corporate and inflation-linked bonds to conventional government bonds.
Alternatives			Attractive diversification characteristics compared with equities and bonds. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated visible revenue streams.
Cash			Cash has defensive qualities in potentially volatile markets.

Equities

Asset	Current positioning	Medium term view	Current view
Equities			Near-term sentiment has been impacted by Covid concerns with the spread of the Omicron variant, central banks’ reaction to high inflation figures, and concerns over Chinese growth centring around the growing property sector crisis. This could result in further periods of equity market volatility. Over the medium term the expectation for above-trend growth and robust earnings should support markets. We maintain conviction in long-term secular themes including technology and health care and energy transition.
UK			Pressure on Bank of England to raise rates has increased, but the government have paved the way for increased spending on infrastructure as well as other areas. Valuations remain relatively attractive and we continue to see more opportunities within the domestic space.
Europe			Tighter restrictions across Europe may impact consumer sentiment and spending which could have near-term growth implications. European earnings are relatively sensitive to a slowdown in China. Monetary policy continues to be accommodative while spending from the NextGeneration EU plan will be supportive.
North America			There remains the potential for further fiscal support, despite political wrangling. Economic activity remains robust and corporate capex could be supportive, although we are watchful of valuations which remain elevated.
Japan			Restrictions remain relatively stringent which may suppress activity despite high levels of vaccination. Potential for fiscal support package in the new year and high savings rates could support the domestic economy.
Asia/ Emerging markets			Normalising Chinese growth and weakening credit impulse may have broader implications for the region. The risk of contagion from the Evergrande Group crisis continues to weigh on sentiment in the near term, although the central bank policy response will be supportive.

Bonds

Asset	Current positioning	Medium term view	Current views
Bonds			Longer-dated government bonds offer defensive characteristics given growth concerns. Valuations however remain expensive. We prefer USD and Chinese government bonds due to relatively higher yields and diversification benefits. We prefer corporate and inflation-linked bonds to conventional government bonds.
Government bonds			Long-dated government bonds provide some portfolio insurance characteristics, despite the risk of rising inflation. Chinese government bonds offer relatively more attractive real yields with lower volatility.
Investment grade			We are mindful of company leverage, spreads below pre-Covid levels and absolute yields at close to all time lows. Opportunities within asset backed securities which offer a relatively attractive yield.
High-yield			Spreads remain close to pre-Covid levels. Default rates remain supported by low cost of debt and expected positive economic growth in the short term.
Inflation-linked			We prefer US TIPS to conventional treasuries and UK linkers given the reduced cost of currency hedging. Inflation expectations have the potential to move higher in response to supply chain concerns and energy prices although we are conscious of the potential impact of rising real yields.
Emerging markets			Emerging market bonds offer selective value across both US dollar and local currency debt. Idiosyncratic country risk remains diverse and a significant driver of returns.

Alternatives and cash

Asset	Current positioning	Medium term view	Current views
Alternatives			Attractive diversification characteristics compared with equities and bonds. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated visible revenue streams.
Absolute Return			Selected opportunities in market-neutral strategies given increased stock dispersion and diversification characteristics.
Liquid private real assets			Long-dated revenue streams and income characteristics remain attractive in select parts of the market. Within this space we see good opportunities in digital infrastructure and exposure to private companies.
Commodities			Gold is attractive as a diversifier and should provide portfolio insurance in the event of a meaningful equity market correction, whilst broader commodities can hedge against sharp rises in inflation.
Short equity vol			Offer attractive returns especially in times of heightened volatility, but we acknowledge the shorter-term correlation with equities.
Cash			Cash has defensive qualities in potentially volatile markets.

Key

	Positive
	Positive/neutral
	Neutral
	Negative/neutral
	Negative
	Up from last month
	Down from last month

Terms

Spread: the difference in yield between a non-government and government fixed income security.

Duration: approximate percentage change in the price of a bond for a 1% change in yield.