Mid-term report

In summary:

Like so many years, 2022 is not panning out as many would have thought when contemplating the year ahead on 1 January. As I write this, UK inflation data has just been released at an eye-watering 9.1%, with just about everyone – including the Bank of England – expecting it to hit double digits in the next couple of months. I think we can say with almost certainty that nobody had this baked into their forecasts for the year ahead just six months ago.

Short-term economic forecasting is, to put it mildly, fraught with danger. As the old joke goes, economists have predicted nine of the last five recessions, and with the world seemingly getting ever more complex and interwoven, it feels like the chances of getting short-term predictions right keep diminishing.

That’s one of the reasons why our approach to asset allocation is to focus on the long term. Within the Investment Team, too many of us have spent too many hours in our prior careers sat in quarterly asset allocation committees having a debate about, for example, whether it should be 6.3% or 6.4% in Japanese equities this quarter. Frankly, we don’t have any insight about this level of granularity over short periods of time, and we don’t think anyone else has either. That’s not to say that we don’t sit down on a quarterly basis and discuss what is happening in global markets and the economy, it’s just that we do it in the context of how this is shaping the markets’ forward-looking, long-term expectations.

When building the strategic asset allocation for our Funds or MPS, our focus is on the next ten years, as it’s easier to predict the long-term outlook than the short-term. This can be equated to the weather forecast – it seems like, most of the time, the weather forecasters can’t say with much certainty whether it will rain tomorrow, the next day or next Tuesday, but they can say with certainty that over the next ten years, its highly likely that between June and September it should be pretty warm! Our approach to asset allocation is much the same.

Our approach is to try and build the most efficient portfolios for the level of risk we want to take. This process involves analysing dozens of asset classes and sub-asset classes to help estimate future expected annualised returns and volatility, as well as how these assets correlate to each other. These inputs are then optimised to give us the most efficient portfolio or, in other words, the most appropriate asset allocation to deliver the highest expected return for a particular level of risk.

By analysing as many asset classes and sub-asset classes as possible (which now number more than 75), we look to build resilience into the portfolios for all times. In essence, our approach looks to buy into those areas that others are shunning, and sell down those areas that others are loving – because when investors hate an asset, the expected future returns are likely to increase, and when investors love an asset, the expected future returns are likely to decrease. All of this is done within a framework to continually maintain considerable diversification, as this provides the resilience if things don’t quite pan out as we hoped – just as we are seeing in 2022.

Looking back on our last strategic asset allocation update in January, the process highlighted the need to shorten the duration of our fixed interest allocation, which was done in both the UK government and corporate bond allocations. So far, this has had a worthwhile positive impact on the portfolios, given the notable fall in longer-duration assets. The scale and speed of the interest rate rises have been such that, while short duration assets haven’t delivered a positive return, they have limited the impact of the losses attributed to fixed interest assets over the first half of the year.

Within the equity element, the optimisation in January saw the allocation to utilities and consumer discretionary sectors removed after very strong prior performance, as the forward- looking returns were more muted. In their place, we added financials which had a much more appealing forward-looking return, particularly given the market expectation for higher interest rates. While utilities have continued upwards, mainly due to surging power prices, consumer discretionary stocks (think Tesla) have suffered as expectations of a recession increase. Pleasingly, financials have proven to be more resilient, although again, they haven’t been entirely immune to the broader falls in equity markets.

With expectations within the global economy changing rapidly, our focus on the long term is helping the portfolios navigate the worst of the falls in the wider market. The in-built resilience has been key to this, with areas such as energy and US inflation protected bonds added at the start of 2021 all contributing to the success of the portfolios. We continue to be honest enough to say we don’t know what will happen over the short term, and won’t try to predict this to chase short-term returns. After all, as John Maynard Keynes said, “it’s better to be broadly right than precisely wrong”. Maybe not all economists were bad after all…