Alex Chappell

22nd April, 2022

Blog, IC Insights

Rain, heavy at times, clearing later. Sunshine will follow.

We often talk about investment volatility being a positive. It’s a hard one to wrap our emotions around, as we are wired to fear things changing, especially with respect to our hard-earned savings. Financial security is something most of us strive to achieve, but as much as we try to provide a steady journey towards that objective (especially for low risk clients), periods of volatility are inevitable.

Across the last decade or so, investors have been fortunate to live in a low inflation and low interest rate regime. It became a market assumption that this environment would be around for the longer term, with the risk of that changing largely ignored. A combination of Covid supply chain disruption and more recently the war in Ukraine has caused an inflation spike, and a policy reaction that for now seems focused on raising interest rates.

Markets have had to absorb that new information, and it has caused a re-pricing of pretty much everything. Consequently, there is much concern around the implications of increasing and persistent inflation, and irrespective of our view that inflation at current levels is temporary and will come down later this year and into 2023, the adjustment has happened. From here we are faced with a new investment opportunity set.

To illustrate the scale of the change, on 13th December 2021, just over four months ago, a UK 10-year government bond was offering a yield of 0.68%. Bonds are a bit like fixed interest accounts that pay you interest with the aim of giving you your capital back at the end, so essentially the expected return on a UK government bond for the next 10 years was 0.68%. Today you can buy that same bond with a yield/expected return of 1.97%. That may not seem like much in isolation, but over 10 years it’s the difference between getting 6.8% and 19.7%.

The re-pricing in Government bond yields is good news in the longer term. There is a pay back in the form of a greater income moving forward which will compensate for the short-term correction in capital value we have seen. The same effects can be seen in other assets. Good quality corporate bonds now comfortably yield 3.5%, compared to around 2% at the start of the year (35% vs 20% over 10 years). Equities have also struggled, as future earnings become less valuable in a world where interest rates are higher, so they’ve also seen a significant correction. In this respect there are speculative areas of the market that have lost more than 50% over the last four months, and single names which are down 70%+. The market adjustment has been significant.

So the effect of falling capital values is an increasing yield, creating higher levels of income and overall better expected returns. Valuations across the board also look much better than they did just a few months ago, and we have been adding to both bonds and equities in the sell off by utilising our cash positions and taking profits on areas that have made solid gains over the last twelve months.

The forward position from here is that valuations look better than they have done for many years, which makes us optimistic about the long term future. In the meantime, we are going to pick up a rising income stream until markets start to improve their valuations. This of course should happen as the news flow improves, and so we continue to look ahead, with our umbrella’s up for now, though confident that blue skies will follow.