Part 2: The aftermath of 2022, where to next?

Following the most expansionary monetary policy in a generation in 2022, economies around the world abruptly pivoted and entered very aggressive economic tightening cycles as inflation rose and unemployment fell. So where did 2022 leave us and where are we heading? How can advisers best position their clients’ portfolios to deal with what is predicted to be a period of extreme economic uncertainty?

In this piece, we bring you the second round-up of the interviews we held with three experts. The first instalment was published yesterday.

Global equities

Luis Sarmiento – senior investment specialist, Macquarie Professional Series

Where are we regarding global equities? So much has happened this year that has exerted immense pressure on equities — high inflation, increasing hawkishness from the central banks, and the Ukraine war.

Luis Sarmiento: Inflation has clearly been the leading economic issue this year — less clear though are the causes and appropriate solutions. Economic observers continue to debate whether inflation is primarily supply-driven — owing to energy shocks and COVID-19 supply chain disruptions — or demand-driven, powered by fiscal policy largesse and robust consumer spending. Central banks, led by the US Federal Reserve, are rapidly raising interest rates, but the ambiguous causes of inflation have complicated the policy response. In the UK, for example, fresh fiscal stimulus is seemingly at odds with monetary tightening. For global equity markets to 30 September, this challenging environment has resulted in nearly all sectors declining over 2022, led by communication services and IT. Energy has been notably strong, while consumer staples and healthcare have proven defensive. Value investing is also enjoying one of its strongest one-year periods relative to growth investing in over 20 years.

As things currently stand, it is presumed that equities will keep dropping for some time to come. What are your thoughts? Have we reached the bottom or is that yet to come?

LS: While the one-year forward price-to-earnings ratio of the MSCI World Ex Australia Index was stretched at the start of the year (20.4x, as of 31 December 2021), global equity valuations have since fallen to 13.7x (as of 30 September 2022), below their 25-year average. Year-to-date market declines have therefore reflected a significant valuation ‘correction’, but further declines remain possible. A traditional recession could impact prices and earnings in equal measure; in the GFC, for example, equity markets saw substantial falls without valuations ever being elevated. What occurs in the current situation will largely depend on whether central banks and governments get it right in addressing inflation.

What could change this downward trajectory?

LS: There are two basic drivers of stock prices — company earnings expectations and valuation multiples. Signs that policy decisions are starting to rein in inflation would give central banks and governments more flexibility to support the wider economy and company earnings. A slowdown or reversal in interest rate rises would also offer support as equities become more attractive on a relative basis.

What actions can advisers take in terms of helping investors pinpoint the right strategy moving forward?

LS: Global equity investors have often focused on whether it is the right time to invest, but the ongoing challenges of inflation, economic disruption, and policy uncertainty mean investment conditions are likely to remain turbulent for some time yet. To navigate markets and build resilient portfolios, investors and managers may be better off focusing instead on selecting the right companies. Disruption creates opportunities for active investors, and carefully selecting individual companies with the right characteristics — for example, pricing power, conservative balance sheets or strong cash generation — are best positioned to withstand higher inflation and interest rates and deliver sustainable earnings growth over the long term.

Property

Corrin Collocott, chief investment officer, BT Financial Group

It has been a turbulent year. Last year when we spoke and did a wrap of 2021, you had plenty of positive things to say about the state of the property sector. Where are we at now? How have things changed over the past year?

Corrin Collocott: The FTSE EPRA Nareit Developed Hedged to AUD delivered 28.60 per cent over 2021. This compares to a disappointing -17.32 per cent in the 2022 calendar year to date. We went into this year aware of the inflationary pressures and the need for an eventual unwind of the record stimulus granted at the start of the pandemic. At the time, it was still unclear how the inflation narrative was going to play out (transitory versus structural).

Adding to the problem, the Russian invasion of Ukraine in the first quarter exacerbated existing shortages and supply chain strains, pushing prices higher. In response to stubbornly high inflation, the market started to reprice expectations for a more rapid and aggressive US Fed rate hike cycle.

Expectations of global growth have also shifted since the start of the year. Earlier on, economic growth remained healthy and supported by strong excess savings, low unemployment rates, and ongoing reopening momentum globally. However, this has been overshadowed by concerns of stagflation as economies tackled issues related to shortages, rising input costs, and tightening liquidity.

Property as an asset class certainly seemed to be dominating during the COVID-19 pandemic. How does the current global predicament differ with high inflation, threat of recession and global unrest?

CC: Real estate tends to outperform during periods of moderate inflation as these periods are usually accompanied by stronger economic activity. Under these conditions, demand for real estate space is strong, replacement values rise, and embedded inflation links in lease contracts can provide some form of inflation hedging. Care should be taken when looking to the past to gauge how the future will play out.

The extent and persistence of inflation have surprised both the markets and central banks on the upside and have required policymakers to move fast and hard in an attempt to bring it back under control. The starting point for valuations is important. REITs were not immune to the impact of rising rates as the asset class was already trading at elevated valuations, to begin with.

It should be highlighted that real estate is a pro-cyclical asset class and its earnings are closely tied to what happens at the macroeconomic level. The dominant narrative last year was very much focused on vaccination rates, global mobility returning, and reopening activity. This optimism has shifted, and the outlook now includes a likely recession. Reported operating performance has so far been positive, but market pricing is moving in the opposite direction, reflecting the market’s concerns over a reversal of the positive fundamental trends.

As an adviser, what does one need to consider for the year ahead in terms of how inflation and interest rate movements could further impact this asset class? The predictions out there in the media are pretty grim.

CC: We are at a point in time where there is a significant lack of visibility in the outlook. Time horizon is key. Volatility may stay elevated in the short term and we are wary of the potential for a deterioration in fundamentals depending on the direction of the economy. Taking a longer-term view, REIT balance sheets remain well capitalised and supply-side dynamics are not flagging as a particular concern yet. Many of the structural themes underpinning the growth in non-traditional real estate sectors remain intact, but valuations should be approached with caution.

Not all REITs are created equal and characteristics such as cost of capital, pricing power, asset quality, etc will drive differences in outcomes. We believe active management is best placed to navigate these uncertainties and take advantage of the price dislocations by remaining focused on bottom-up fundamentals, rather than short-term sentiment swings.

Would you say that property still remains a key feature of a well-diversified portfolio? Why?

CC: Listed real estate has historically delivered competitive total returns. Over the longer term, it offers diversification benefits due to its low correlation with other asset classes like equities and bonds.

The unique investment attributes and return drivers are often an appealing aspect of REITs. It is attractive as a source of income due to the steady dividends, while also having the potential for long-term capital appreciation.

The opportunity set continues to expand as capital is directed towards non-traditional property types that tap into the longer-term secular trends such as ageing demographics, housing affordability, and an increasingly digitalized economy. This is creating growth opportunities in niche property types such as data centres, multi-family homes, senior housing, etc.

ETFs

Julia Lee, SPDR ETF equity investment strategist APAC, State Street Global Advisors

Have global market uncertainties slowed growth in the ETF industry?

Julia Lee: The good news is the ETF industry continues to experience significant fund inflows, new entrants and sustained product innovation.

More than US$1.5 trillion in new investments has occurred globally in the year to date (as of 20 September 2022), while in Australia, the performance has been similar with more than US$2.5 billion of new flows occurring in the last 12 months (as of 20 September 2022).

That said, net flows globally are around 30 per cent lower than the record US$739 billion for the same period last year, principally because most ETFs invest in equities or bonds — both of which have been under sustained pricing pressure in line with overall market volatility.

As a result, investors have looked to protect their capital. Add into the mix higher interest rates, higher inflation, global geopolitical instability, and company outlooks being weaker, and the strongest part of the industry has been in defensive and safe-haven sectors.

This means healthcare and utilities have been some of the best-performing sectors of ETFs. Energy has also outperformed with the Ukraine-Russia conflict pushing up global energy prices.

On the flip side, the worst sectors have been the growth-focused areas like technology, where companies typically need new rounds of capital to grow until they are profitable and financially sustainable. And those capital rounds are becoming more difficult to secure through risk-averse investors.

What this means is that high-yield, low-volatility and quality sectors have been relatively good performers this year while growth has underperformed.

What are some of the key tests that ETFs have faced this year?

JL: Higher for longer has been the catch-cry this year. Rising interest rates to combat higher inflation has been one of the key tests in 2022.

Nevertheless, ETFs continue to be resilient in the face of:

• War
• Rising inflation
• Interest rate increases
• The prospects of a global slowdown

ETFs continue to provide investors with the flexibility needed to strengthen their portfolios with either defensive assets or to take advantage of any emerging opportunities.

Within this context, investors are essentially considering two factors — risks and returns.

On the risk side, war, a pandemic and a cyclical economic slowdown have all been challenging. On the return side, a strong US currency, rate increases and accelerating inflation have meant that while corporate revenues have generally increased, that hasn’t translated into a corresponding lift in company profits, as margins have been under pressure from rising costs.

Which ETFs perform best in an inflationary environment? Thematic ETFs have particularly suffered this year.

JL: Interest rates globally are increasing at rates not seen for 40 to 50 years, as post-COVID-19 supply chain shortages create inflationary bottlenecks, while simultaneous pent-up consumer spending fuels aggregate demand, leading to higher economic growth.

Within that context, high dividend and commodity ETFs have performed well.

The evidence?

While the S&P/ASX 200 has lost 4.9 per cent in the year to date*, the SPDR® MSCI Australia Select High Dividend Yield Fund (SYI) has gained 2.5 per cent*.

High dividends tend to outperform in times of volatility. Inflation and rate increases are currently creating that volatility, which is seeing investors move to the safety of dividends. Dividends are paid despite good or bad economic conditions. This offers investors downside protection in market pullbacks.

On a sector-by-sector basis, commodities historically perform well in inflationary environments. This has been true in 2022 with energy as a key factor in rising global inflation, and that has flowed through to ETF performance.

One obvious example is the SPDR® S&P/ASX 200 Resources Fund (OZR) which has been a big winner, returning +11.5 per cent year to date.

Next year, the big question about commodities will depend on China’s COVID-19 journey and stimulus.

In contrast, thematic ETFs are primarily growth-focused industries and companies that are experiencing structural tailwinds. While these tailwinds could last decades or even centuries, they are based on long-term views. What has been happening in markets is cyclical, as it is perfectly normal for economic conditions to move up and down.

Unfortunately for thematic ETFs, this means that growth has been out of favour and this has impacted negatively on both performance and inflows of new funds.

What’s ahead for ETFs?

JL: More innovation may be on the way.

The big mover in 2022 could be the creation of more fixed income ETFs. The global bond market is currently valued at US$120 trillion, and investors are currently searching for yield.

The second trend may be a continued move towards green ETFs as regulators and investors focus their shifts towards the environment.

The green wave swept Europe, the Middle East and Africa first, and we expect to see a greater focus in Australia in line with a greater focus from regulators.

More broadly, ETFs are simply a reflection of the overall market. Looking ahead, each cyclical downturn is a time for experienced investors to buy businesses at a lower price than what they would pay in a cyclical upturn.

However, nothing lasts forever. As the market moves from pricing in peak inflation, peak interest rates and peak defensive behaviour, the focus will return to where it can make the best returns.

Therefore, next year will be a time for investors to watch out for the inflection point from capital protection to potential capital appreciation.