It’s been a long and winding road for markets for the first half of 2022. With stubbornly high inflation, rising interest rates, supply-side disruptions and the increased risk of recession, the outlook for investors continues to provide plenty of uncertainty.

In a recent live panel discussion, James Biggins, Distribution Director at Channel Capital, sat down with Jamieson Coote Bonds Chief Investment Officer, Charles Jamieson, Cbus Super CEO, Justin Arter and Chairman of the Jamieson Coote Bonds Advisory Board, Mark Burgess to discuss the market and macroeconomic outlook and how we can look to position and de-risk portfolios in the months ahead.

We share a summary of their views and unpack some of the ideas and themes that were addressed. In short, considering the weakened trajectory for financial markets, investors are concentrating their efforts now on defence. High grade sovereign bonds – across the range of likely outcomes ahead – can play a solid role in protecting portfolios for these uncertain times.

Central Banks go on the defensive

With inflation soaring to new highs, Central Banks have responded by tightening monetary policy to slow demand. These decisions will take time to fully wash through economies, and consequently there is a real risk of policy missteps – Central Banks, in effect, doing too much or too little. Jamieson believes that the Central banks will err by going too far – as the pace of the rate hiking cycle has hit extraordinarily fast and that the lead indicators such as employment and inflation are showing that markets will likely slow materially.

“The concern lays in the fact it’s going to become harder to restimulate the economy without reigniting inflation. The sole objective in what Central Banks are doing is to destroy inflation, and it is likely that they will destroy the economy in the process, as many policy rates are now up around neutral,” said Jamieson.

Burgess also noted that monetary policy and uncertainty have weighed in heavily on the decision of Central Bankers to steer economies through the tough conditions we are now facing.

“The tailwinds from the past thirty years – especially for risky assets – have been strong with falling rates, globalisation, high profit growth and share market gains which have now been challenged by the Covid-19 pandemic. From a markets perspective, the liquidity in the financial system has been incredible, however, uncertainty has heightened market volatility in the first half of 2022, as we are on the brink of an economic slowdown."

He concedes that it’s also hard for investors to ignore the risk of a looming recession to ease pressures on inflation as many countries are now well advanced in their hiking cycles. With policymakers going too aggressive too early, the answer remains whether growth will slow too much to orchestrate a soft landing.

Managing the upside and the downside of portfolios – taking the lead from super funds

It’s been an unpleasant start to the year for superannuation fund performance and portfolios were extensively impacted by market declines as well as higher volatility. The super industry had to actively play to its strengths in this downturn, particularly Cbus Super which is one of Australia’s largest super funds and manages over A$70 billion for the construction and building industry. According to Arter, the standard 60/40 portfolio has experienced its worst outcomes in over thirty years, though due to this shock in the market, Cbus has been able to tactically reallocate its portfolios from equities to bonds as well as private markets exposure.

Arter also noted the importance of taking up a higher bond exposure in this environment where Cbus was able to shift its portfolio position.

‘‘Our (equities) allocation was a bit challenging though we were able to modestly decrease our equities exposure and progressively lift our bond exposure by 2% when we saw strong value present."

When rethinking portfolio allocations, Burgess says it’s important to look forward (not to rely exclusively on past experiences) as your technique for asset allocation is going to be crucial.

“It’s all about scenario analysis. This methodology will be beneficial to test from a top-down and bottom-up approach and view how the correlations will occur from macroeconomic and diversification levels. While scenario analysis could sound dire in this environment, there are always winners to be found.”

An unsettled market brings an opportunity for bonds

Much has changed since the first half of the year − markets have priced in aggressively tighter policy and investors are starting to reallocate bonds back to their strategic allocations. Despite this favourable opportunity, some investors remain uncertain while yields are still rising, however sitting on the fence could be a costly mistake to their portfolios.

Jamieson explains that inflows have once again began to flow through as investors seek to protect and defend their portfolios through Government bonds, as they remain very liquid and less volatile in challenging times.

“We have seen a strong movement back towards fixed income, we anticipate duration will have a genuine role to play in these turbulent times. Post the initial shock of spiking inflation and subsequent and dramatic policy normalisation, the alpha opportunities are real.”

Jamieson also noted that we may see a further wobble towards the end of the year as goods inflation has moderated, services inflation is sticky for now, but the important swing factor will be seen in the energy and commodities sectors.

“It won’t be a nice linear return to 2-3% inflation as there is a lot of latitude here that will play out to get to a disinflationary environment and the policy levers will have to be constantly utilised rather than the ‘set and forget’ mentality post the Global Financial Crisis.” said Jamieson.

Adapting to the changing environment

On the positive side of interest rate rises, current yield levels mean that Government bonds are regaining their defensive qualities again. Investors can now get back into Government bonds and achieve a healthy yield, and if the recessionary scenario plays out and rates fall from there, fixed income will again provide the diversification and protection benefits that they have proven to provide during market downturns. Although with the continued uncertainty and challenges ahead, investors should tread carefully to assess whether getting back into bonds is an attractive opportunity for their portfolio.