2021 was an awkward ’steady state’ year for financial markets: bonds delivered the worst returns in a quarter of a century except for one year (1999), while equities secured top-quartile (or better) returns over the same period.
Looking under the bonnet, this makes perfect sense. Government bonds last year were driven by both higher inflation breakevens and lower real rates in contrast to recent years where they have tended to move in the same direction.
Breakevens, or inflation discounted by bond markets, link closely to equity cash flows, which have rarely looked better: global profits expanded by an eye-watering 53% in 2021, broadly in keeping with the historical ‘beta’ to moves in anticipated inflation. At the same time, real yields, or the rate of discount applied to future cash flows, have rarely been so supportive. Real yields as low as -120bp at 10 years and -60bp out to 30 years have been a panacea for equities, as exhibit 1 shows.
Setting out the base case
We, in line with the consensus, expect above-trend growth in the G10 economies in 2022, with inflation peaking around the summer and monetary policy broadly on the back foot. We expect the Federal Reserve to raise US interest rates three times in 2022, the ECB to hold rates low for longer and the Bank of England to be behind the curve.
Better nominal growth rates should support fair corporate earnings growth, and with company balance sheets broadly in good shape, holders of assets across the capital structure should do relatively well. The consensus forecast is for profit growth of around 8% compounded in the next two years.
The broad base case set-up would favour both equities and corporate bonds.
What are the risks?
The left tail to this base case is fattening, indicating risks to the underlying assumptions.
We enter 2022 cautiously ‘neutral’ in our risk taking from an asset allocation perspective – that is to say, a bit below the mid-point of tracking error or volatility ranges across portfolios.
Within broad risk neutrality, our exposures are pointed towards being short duration, long selected equity markets and, more tactically, long commodities.
One particular risk that is preoccupying us is reflected in this positioning: a prospective un-anchoring of bond yields, and real yields in particular, at a time when asset valuations across the board are full.
The case for higher bond yields and higher neutral rates is not difficult to make, especially at current valuations.
- The last two years have seen global monetary and fiscal stimulus on a scale not witnessed outside of times of war. This is now being unwound.
- Labour markets are increasingly tight in many developed countries, with a return of labour bargaining power for the first time in three and a half decades.
- Globalisation, which has been an important underpinning for the steady downtrend in bond yields since the mid-1980s, is in reverse.
- And the inflation shock delivered by COVID-19 has been both significant and more persistent than hoped, yet financial conditions are extremely easy.
A move up in bond yields will likely be spurred by ultra-low real yields moving higher as central banks tighten their policies, rather than by breakevens.
At the same time, the abrupt rate rise cycle priced in by markets seems curious to us; we would sooner see a steepening of the curve, notably in the US, than further flattening as the Fed removes the punchbowl. Today, roughly a quarter of our risk budget in an unconstrained multi-asset portfolio would be directed at being short US and European government bonds.
As higher bond yields raise the discount rate for equities, multiples may be challenged (see exhibit 1).
A look at our positioning
The price/earnings ratio on the US equity market is as high as any time since late 1990s and dividend yield is a whisker away from the lows. Still, we continue to favour equities: they take up the bulk of our overall risk.
However, we are increasingly focused on regions that we believe are both less sensitive to real yield moves at current valuations, and where strong cash flows are expected in 2022 and 2023 in both absolute and relative terms. Europe ex-UK, US small caps (vs. large caps), Japan and – to a degree – emerging markets all display this combination (see exhibit 2). Notably, domestic monetary policy in Europe, Japan and China are staying easy or are turning easier at the fringes, offering some counterweight to higher US real rates.
Japanese equities, for instance, have consistently tended to outperform global equities in periods of rising US real rates.
On the one hand, this reflects the long operational leverage of Japanese companies (with high fixed to variable costs offering nice gearing to the cycle). On the other hand, in aggregate corporates have short financial leverage (with the highest cash balance of any major market).
Valuations in Japan today are cheap, earnings expectations are punchy and policy is staying easy (monetary) or turning easier still (fiscal).
More tactically, we also favour commodities that should find support from the turn in China’s policy tone, meaningful supply shortfalls, and broader insensitivity to moves in either cash flows or discount rates.
 As measured by the Global Aggregate unhedged bond index in USD and the S&P 500 and MSCI ACWI equity indices respectively. Q1 2021 was torrid for government bonds: they had their worst performance in 40 years.
 2018-2020, for example, where breakevens and real yields fell similarly
 This can be thought of the steepness of the line of best fit between expected risk and expected return across asset classes. The steeper the line, or greater expected return per unit of risk, the larger risk appetite. Neutral sits in the middle quintile (20%) of a tracking error or permitted volatility.