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Blog Posts — December 14, 2021

Multi-asset investing in 2022: “And the winner is…”

by Christoph Schon, CFA, CIPM

As 2021 draws to a close, the focus inevitably shifts to the year ahead. What do we see coming and how can investors capitalize on it? The short answer is as follows. Rising costs of consumer goods and raw materials are likely to remain at the forefront of investors’ minds in the months ahead. That said, our stress testing analysis suggests that stock markets could continue to rise, if higher prices are still seen as signs of a recovering economy—as they have been over the past 21 months. With tighter monetary policy fully priced into asset valuations, we believe that the greater risk now is that central banks could leave rates lower for longer, which might be interpreted as a sign of weaker-than-expected economic growth. In terms of investment opportunities, we conclude that high yield bonds offer the most promising risk-return characteristics in 2022 for all examined scenarios.

And here is how we got to this conclusion…

The main performance drivers in 2021: inflation, commodities, and interest rates

Looking at a year-to-date performance attribution using the Axioma Worldwide Macroeconomic Projection Equity Factor Risk Model in the charts below, we find that rising inflation expectations and higher costs for energy and raw materials explained half of the return of the STOXX® USA 900 (left). Adding Eurozone breakeven inflation to the mix, the four factors combined accounted for three quarters of the 2021 performance of the STOXX® Europe 600 (right). Individual country and currency performance also played a role, as the United States beat most other stock markets, especially during the second half of the year, while the euro depreciated against the British pound, the Swiss franc, and the US dollar.

Macro-factor contributions to stock-market returns: US (left) versus Europe (right)

Source: Qontigo, Axioma Worldwide Macroeconomic Projection Equity Factor Risk Model

Inflation expectations were also the major driver behind the surge in long-term bond yields, especially in the United States. The chart on the left below shows that the relationship between the 10-year Treasury yield and the corresponding breakeven-inflation rate was mostly positive in 2021. The notable exception occurred in the spring, when growing concerns over the pace of consumer-price increases boosted long-term nominal yields, while inflation expectations remained anchored by extensive central-bank reassurances and support. That said, the real yield (represented by the light blue area) soon fell back to -1%, so that the year-to-date rise in the 10-year nominal yield is exactly the same as the increase in the same-maturity breakeven rate.

Breakeven inflation and sovereign yields: US (left) versus Eurozone (right)

Source: Qontigo

The picture was different in the Eurozone, however, where increases in the 10-year German Bund yield were much more moderate, due to the European Central Bank’s insistence on maintaining its accommodative monetary-policy stance for much longer than its American counterpart. In another contrast to the US, expected long-term inflation did not break above the 2% central bank target, despite realized consumer-price growth surging to its highest level in three decades.

Not too surprisingly, index-linked government bonds were among the best-performing assets in fixed income, returning between 5% and 6.5% in the US and Europe, compared with losses of more than 2% on nominal sovereign debt. Investment grade corporate benchmarks were also pushed into negative territory by higher risk-free rates, while spreads remained largely unchanged relative to their levels at the start of the year. High yield securities, in contrast, benefitted from higher coupons, as well as tighter credit-risk premia, which offset most of the uptick in sovereign yields.

Biggest risks for USD bonds: interest rates for investment grade, credit spreads for high yield

Looking at predicted volatility for USD fixed income assets going forward, there is also a clear divide between lower-rated securities versus higher-quality debt. The chart below shows the predicted volatility of USD-denominated sovereign and corporate bonds. The model was calibrated on weekly returns over 5 years with a 1-year half-life. The volatility numbers were normalized for an average portfolio duration of 8 years.

Predicted volatility for USD fixed income assets

Source: Qontigo, Axioma Risk™

At first glance, the overall risk forecasts seem quite homogenous across all debt types and credit ratings, ranging from 5% to 6.5% for most categories. It is also worth noting that all investment grade securities have almost identical values, with most of the risk coming from fluctuations in risk-free rates, which suggests that creditworthiness is not a major concern for investors in that part of the fixed-income market. However, the picture changes very quickly once we cross into speculative territory. Even though double-B-rated paper exhibits the same overall predicted volatility as higher-quality debt, its performance and risk are now dominated by changes in credit spreads. Inflation-protected government bonds show surprisingly little exposure to inflation risk. The most likely reason for this is the relatively long calibration period, in which breakeven rates fluctuated significantly less than interest rates.

What’s in store for 2022? A stress test can tell us…

The relative importance of risk factors is also important for what we can expect in terms of asset-class returns in the year ahead. Concerns about soaring consumer prices and costs of energy and raw materials are likely to remain at center stage. The recent upticks in short-term interest rates and bond yields reflect the anticipation of drastic central-bank action in the coming months. This in itself creates the additional risk that market participants overestimate the lengths to which rate-setters are prepared to go to battle price increases that in their view are still “transitory”. European Central Bank President Christine Lagarde has repeatedly warned traders not to expect any adjustment in interest rates for at least another year. Similarly, the Bank of England shocked punters by not raising its base rate in November, despite markets considering it a near-certainty.

We conducted a range of stress tests in Axioma Risk™ to simulate the impact of all these scenarios on the returns of various asset classes in Europe and the US. We shocked each variable separately by the following amounts:

  • 10-year US breakeven inflation +0.5%
  • 10-year Eurozone breakeven inflation +0.5%
  • 10-year US Treasury yield +0.5%
  • 10-year German Bund yield +0.5%
  • Oil price +20%
  • Commodity prices (ex-energy) +7.5%
  • July 2021 Fed Funds future price +0.30 (no Fed hike)

We used daily returns from the past three months to estimate the betas and covariances with the underlying pricing factors, as this period encompasses an environment of surging inflation (realized and expected), rising interest rates, and a major revision of monetary-policy expectations. The results of the stress tests are shown in the charts below.

Simulated returns for selected US (left) and European (right) asset classes

Source: Qontigo, Axioma Risk™

It is interesting to note that all the economic scenarios seem to have almost identical positive impacts on share prices on both sides of the Atlantic. It indicates that rising inflation, long-term yields, and input prices would still be considered as signs of a recovering economy, rather something to worry about. Higher interest rates are clearly the biggest concern of bond investors, but there appears to be a regional divide on the potential impact of inflation expectations. While for the US, the breakeven-rate and sovereign-yield scenarios have almost identical effects on nominal Treasuries and investment grade corporates, inflation seems to be much less of a concern in Europe. And with regard to the positive impact on European stock markets, the regional origin of the inflation does also seem to be of lesser importance.

The fact that index-linked bonds only benefit from direct rises in breakeven rates, but exhibit similar losses to nominal securities in the other scenarios, confirms our earlier finding that risk-free rates tend to be the dominant source of risk and returns, even for inflation-protected securities. This was once again in contrast to high-yield debt, where opposing spread movements seemed to cancel out changes in sovereign yields. It is worth noting that the analysis simulates only changes in clean prices. High-yield bonds can, therefore, be expected to provide positive total returns when coupons are considered.

The major risks and opportunities for 2022

So, what does this analysis tell us about the risks and opportunities in the year ahead? Here is what we found for each asset class:

  • Equities can continue to rise, even in an environment of accelerating consumer prices and higher costs for energy and raw materials, as long as these are still seen as signs of a recovering economy. The greater risk comes from central banks not tightening monetary conditions, which could be interpreted as expectations of weaker economic growth.
  • Index-linked securities will only benefit from a direct increase in inflation expectations. In most other scenarios, the negative effect of higher interest rates is likely to prevail.
  • The risk and performance of sovereign bonds and investment-grade corporates are likely to be dominated by fluctuations in risk-free interest rates.
  • High yield debt offers the best risk-return characteristics, as changes in sovereign yields are likely to be offset by opposing spread movements, while high coupons provide additional income.