Markets have been volatile recently. There has been a lot of challenging news. High inflation. High oil prices. Rate hikes. The end of quantitative easing. The start of quantitative tightening. Russia and Ukraine. Coronavirus.

A diversified portfolio had few places to hide in January. This month, we aim to answer some of the key questions for the outlook.

Will inflation slow this year?

Inflation has increased to the highest level in 40 years in the US. Inflation is above the RBA’s 2%-3% target in Australia. High inflation reflects supply chain disruptions globally, higher energy (notably oil) prices, and labour market shortages due to Covid19.

We expect inflation will begin to slow over H2 2022. Inventories and trade data suggest some of the supply chain disruptions are abating. Covid19 remains a concern, but labour supply is returning. And rate hikes from developed market central banks will begin to slow growth and inflation later this year.

Will the RBA and the US Fed hike rates this year?

We expect both the RBA and the US Fed to hike rates this year. The Fed has all but confirmed a March rate hike. Markets have moved to price as many as seven 0.25% rate hikes this year. In Australia, the RBA has been less forthcoming on the likelihood for rate hikes this year. But high inflation, rising wages and solid growth from a post-pandemic reopening is likely to force them to a rate hike in early H2 2022.

We don’t think the RBA will hike by as much as markets have priced. Market expectations are for the cash rate to reach around 1.30% by December. We think that is less likely. Instead, we could see the Australian dollar begin to strengthen as China recovers and Asian economies begin their reopening. This would take some of the pressure off the RBA to hike aggressively.

Is quantitative tightening a risk to the outlook?

Quantitative tightening is the reversal of the ultra-accommodative asset purchase programme enacted by the US Fed during the pandemic. We expect the Fed will begin the process this year. The Fed will allow longer-dated assets to mature. This will remove liquidity from the system, and we expect will put some upward pressure on longer-dated bond yields. Higher bond yields will further tighten financial conditions. But we don’t expect it to lead to recession in 2022 or 2023. Instead, we expect it will allow the Fed to hike the Fed Funds rate by less than markets are currently pricing.

Is the Russia and Ukraine conflict a risk to the medium-term outlook?

The Russian military presence along the Ukrainian border is a source of uncertainty for global markets. It remains unclear whether the conflict will escalate to occupation, invasion, or military involvement from NATO. There is still a possibility of a diplomatic resolution.
Equity markets have responded to the uncertainty and the increase in energy prices with declines. These declines are typical of historical conflicts and the related uncertainty. Unless the situation devolves into an outright invasion with significant NATO military involvement, we expect this will be a near-term impact only.

What is the impact of high oil prices?

High oil prices have put upwards pressure on global inflation. High oil prices also act like a tax on household finances, particularly in the US. The result is slower growth, and higher inflation. This is a challenging scenario for the US Federal Reserve.

Oil prices have increased due to the challenges that OPEC+ have had in meeting their supply targets coupled with solid global demand. Price increases have been exacerbated by the Russia-Ukraine standoff. We expect oil prices may remain elevated for some time, but will not continue to rise at the pace of the past 12 months. That should help cap the impact on inflation and households.

Should I be invested in fixed interest?

Fixed interest markets have delivered low or negative returns globally over the past twelve months. We expect interest rates will continue to drift higher this year. That will be a challenge for near-term returns. But yields have moved higher and that has improved the medium-term return prospects. Our return expectations for US and Australian sovereign bonds has increased, while investment grade and high yield credit returns look reasonable relative to history.

Fixed interest remains an important part of a diversified portfolio. Sovereign bonds provide some of the only reliable downside protection to retail portfolios during market downturns. While we moved to be maximum underweight sovereign bonds during mid-2021, we have retained some exposure from a risk management perspective.

Alternative credit may be an option for some investors. This typically means taking on some illiquidity and credit risk in return for higher yields. The Portfolio Advisory Service is able to help with these allocations.

Can equities recover from the poor start to this year?

Global equities have suffered as interest rates have moved higher and uncertainty has increased. A rotation out of growth and tech stocks has been painful for most portfolios. We think solid earnings growth this year will help equity markets recover – making the recent price action a correction rather than a deeper bear market.

Diverging monetary policy and economic growth will be important for equity allocations. In January, we changed our outlook for global equities to favour Australia and Asian equities over US and other developed market equities. We continue to expect those markets to outperform over the medium-term.

What actions should I take in my portfolio?

Market volatility is a challenging time for investors. It is important not to take knee jerk reactions that are not aligned with your investment process or philosophy. At the same time, reviewing exposures and holdings when markets move is sensible. The recent price action may be a good reminder to rebalance if the strong equity returns in 2020 and 2021 have moved the portfolio away from the strategic asset allocation. For portfolios that are dynamically managed within a managed account structure, the volatility is a reminder to review dynamic positions and ensure the underlying thesis remains sound.

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