A muddled inflation picture, uncertainty over if or when rates might be cut and markets at all-time highs: what should investors do? Two Schroders experts, Alex Funk and Tamara Jameson, give their views on the topic.
“We are going to see more volatility, that is actually one of the things that comes out of our research on the 3D reset,” says Tara Jameson, Analyst, Multi-Asset Investments at Schroders. “The 3D reset is the big three structural forces that are going to create more inflationary pressure going forward : demographics, deglobalization and decarbonization. The reset is creating inflationary pressure. The inflation will not necessarily be higher in the end, but there will be cycles. The central banks have a very difficult job on their hands at the moment. They have had to bring inflation down a long way and much still needs to be done. At the moment, markets think that they can engineer a soft landing. But obviously these outcomes can be binary, and there is always the risk of a hard landing.”
“You almost don't know the risk until it appears,” says Alex Funk, Chief Investment Officer, Schroder Investment Solutions. “We saw a little bit of that with Silicon Valley Bank and we have seen a little bit more banking stress more recently as well. The market is extremely reactive on inflation data, the expectations on the Fed, and we're seeing it in sort of sensitive areas. In the bond market, we have almost become a little bit more accustomed to sort of ten basis point moves in the US treasury curve. And that shows volatility.”
The market is pricing in a nearly 82% chance of a quarter point cut by June. The situation can change. But what happens once the Fed starts to cut? Alex Funk : “On average, from the point that the Fed starts to cut, equities actually outperform by about 11% relative to inflation, which is quite significant. You can see that this euphoria is being priced back into the market.”
Equities, fixed income or cash ?
Is riding this inflation wave just about investing in equities, and in particular US equities or is there more life after cash?
“Equities are a very good asset to hold long term if you want to beat inflation,” says Tara Jameson. “They're one of the best at outrunning inflation. But that doesn't mean you want to be sort of fully juiced up on equities all the time. You definitely want to hold a diversified mix of different asset classes because they bring different things to the table. One of the fortunate things about interest rates having risen to where they are today is that you can actually earn quite a good yield now on fixed income. Interest rates can become a return generator in the portfolio, whereas previously they were more just there as a diversifier, because they didn't really pay you anything. In the last year, we have seen some very strong returns from e.g. corporate bonds. The additional spread that you earn for taking on corporate credit risk has really contracted a long way. At the moment, in terms of taking risk in portfolios, we are preferring equities to other parts of the market like corporate credit. But that can change. It just depends what the market is pricing.”
“Within equities, you have to think about it a little bit as well,” says Alex Funk. “The magnificent seven are truly magnificent. Virtually no debt on the balance sheet, strong cash flow, high moats in terms of the products and services they have. Ongoing tailwinds from their investment in AI and the excitement around that. One has to acknowledge that there are other parts of the market and other parts of the world that could either benefit from that as well when we have a broadening out and ultimately re rate from a perspective of being slightly depressed over the last little while. Not only across asset classes, but within asset classes, you need to think about that diversification element as well.”
Given that the rates look like they are peaking and possibly on the way down, is cash dead now for investors?
“I don't think cash is dead,” says Tara Jameson. “It is always an option as an asset class. But I do think that fixed income is becoming more exciting. The one big difference between government bonds and cash is that government bonds do have that potential to have that negative correlation with equities in a severe risk off situation. There have been times in markets before when equities were falling and bonds generated a positive return in the portfolio. Cash isn't going to do that for you.”
Further reading and listening : Podcast: Life after cash and investing at all time highs
