At our latest investment committee meeting, the discussion focused on the nature of the global economic cycle into and during 2022. The first part of 2021 was characterised by a surge in economic growth and corporate earnings, which supported a strong equity market rally.

More recently, there have been two major changes to this supportive environment. First, economic growth has slowed, notably in China, but also in the developed world. Second, there has been a marked acceleration in the pace of inflation.

High inflation poses a potential threat to the cycle and many asset prices for various reasons. It increases the potential for earlier interest rate rises than the market expects, squeezes real incomes, and might become more deeply embedded the longer the surge lasts.

Our analysis of the situation suggests the investment environment will remain moderately positive. However, conditions are less positive than they were at the start of 2021, and some downside tail risks are emerging.

Macroeconomic overview

The current situation remains quite bullish. Growth slowed sharply in Q3 but the latest economic data has surprised to the upside and the picture for Q4 is for a re-acceleration in growth. Some supply chain bottlenecks are showing signs that constraints are easing, semiconductor shortages are less extreme and shipping rates have started to fall.

The Q3 earnings season has shown that most companies have been adept in managing inflationary pressures so far. Profits have exceeded expectations and margins are reaching record highs. Revenue growth has allowed for operating leverage to continue and more than compensate for any cost pressures in the system. Earnings expectations continue to be revised higher into 2022, which is a positive sign.

With strong earnings, reaccelerating growth and early signs of bottlenecks easing, markets are set for a strong move higher since the correction in September. News of a Covid pill that could significantly reduce hospitalisations of those most seriously ill has also been a major boon for the market, in particular for those sectors most sensitive to the reopening of the economy.

Financial markets

The relationship between inflation expectations and real yields seems to have broken down. Inflation expectations in many developed markets are at 10-year highs, yet real yields have fallen to record lows.

Nominal bond yields are lagging inflation expectations, and central bank policy is certainly a possible cause for this disconnect. Forward guidance is targeting a bond yield that is well below current inflation levels, which explains why real yields are so negative. We think that as central banks gradually reverse their extremely accommodative policies, nominal bond yields are likely to rise and real yields will become less negative.

Inflation and real yields (%) – Inflation expectations have moved to 10-year highs, yet real yields are at record lows as nominal bond yields have yet to respond to the inflation risk. Central bank intervention may have something to do with this. A tightening of monetary conditions may lift real yields.

Source: Saranac Partners.

In such an environment, we would expect to see a steepening of the yield curve as longer duration bond yields move higher faster than shorter duration yields. We are positioned for such an outcome in portfolios with our focus on credit risk and short duration.

In the event of higher yields and a steeper yield curve, we would expect cyclical and value-related stocks to perform well within equity markets. Very high-growth, high-valuation stocks could struggle given their sensitivity to long bond yields.

We have maintained a barbell strategy within our equity allocation for over a year now, balancing our core, high-quality growth stocks with exposure to more cyclical, and cheaper, stocks that we believe will benefit from economic reopening.

While our growth stocks trade at a valuation premium to the market, the premium is relatively small and we have no exposure to super-charged growth stocks with no earnings and extreme valuations.

A shift to increasing the proportion of cyclical stocks with a valuation discount would make sense in the environment we lay out here. Banks, logistics companies and industrial stocks are candidates for inclusion.

Gold has been a disappointing investment this year, its recent rally notwithstanding. The rise in inflation, higher inflation expectations and deeply negative real yields all failed to ignite a sustained rally

Gold and real yields – Over recent years there has been a tight relationship between the gold price and real yields. The drop in real yields to extremely negative levels this year has failed to elicit a move higher in gold. If real yields move higher, it could spell trouble for the gold price.
Source: Saranac Partners.

In the scenario of higher bond yields and less negative real yields, there is a risk that the gold price drops significantly, as was seen during 2013 as markets prepared for the Fed to taper QE after the financial crisis. We reduced our allocation to gold to 3% at the start of the year and we are debating cutting it from portfolios.

However, in current markets there are increasingly few portfolio diversifiers that protect us from the risks of much higher inflation and the volatility that would create, so we are maintaining the position for now.


Portfolio Positioning

We are not making any changes to our portfolios this month. However, the shifts in our outlook, as well as our belief that bond yields should rise and yield curve steepen, prepare us for possible changes in the near term.

The more immediate challenge relates to fixed income markets and real yields. The environment suggests a very short duration approach to fixed income and a tilt toward more cyclical and value orientated equities.

Further out, we are not ignoring the possibility that a squeeze on real incomes from high inflation leads to an unexpected slowing in macro momentum and heightened fears that the cycle is nearing the end. Such a scenario would require a de-risking of portfolios and we want to be alive to this possibility.


Portfolio Performance

Current Asset Allocation


Monthly Returns

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total
2016 0.74% -1.55% 1.93% 1.10%
2017 0.21% 2.63% 0.42% 0.29% 1.40% -0.34% 0.96% 0.60% -0.38% 1.73% 0.22% 1.39% 9.47%
2018 1.18% -1.17% -1.33% 1.53% 0.52% -0.26% 1.13% -0.47% 0.53% -2.88% 0.74% -2.44% -2.98%
2019 2.91% 0.53% 1.32% 1.88% -1.71% 3.58% 2.58% -0.98% -0.41% 0.09% 0.67% 1.24% 12.21%
2020 -0.97% -1.69% -9.80% 4.26% 3.12% 1.21% 0.94% 1.64% -0.02% -0.23% 3.33% 1.52% 2.59%
2021 -1.17% -0.41% 1.70% 3.17% -0.32% 1.28% 0.07% 1.57% -2.17% 1.39% 5.10%


Performance figures from inception (30th September 2016) to end May 2017 are based on model portfolios, simulated from a full record of trading decisions and execution levels quoted, are readily available for review. Performance figures from June 2017 onwards are based on an aggregation of actual client portfolios whose mandate most closely follow the Moderate Risk model. Dividends have been included on an accruals basis in both cases. All performance is shown exclusive of fees as charging structures may vary. Your capital is at risk and past performance is not a reliable indicator of future performance.

Source: Saranac Partners, as at 31st October 2021. Inception: 30th September 2016.