BY INVESTMENT STRATEGIST AND PORTFOLIO MANAGER, HAROLD STRYDOM
Scenario modelling has formed part of Peregrine’s investment philosophy for two decades. It enables us to better understand potential market outcomes and construct stronger portfolios. The Asset Management team has a three year, core or “High Conviction” scenario view, which is expressed as macro and market assumptions. These assumptions include economic growth, inflation, interest rates, price-earnings (PE) multiples, and credit spreads amongst others. Our asset valuation models produce expected returns for various asset classes, based on these expectations. This section is used to summarise our High Conviction view and the resulting asset signals.
The impact of the Russia-Ukraine war on commodity prices, especially energy, has resulted in global inflation moving even higher and is likely to remain stickier than previously assumed. Central banks have commenced on an aggressive monetary tightening phase to bring inflation under control, with interest rate hikes and quantitative tightening. As a result, global economic growth is expected to moderate sharply during 2022. Europe is likely to be impacted more compared to the US, China, and other parts of the world. The risk of a global economic recession has increased but remains below 50% in our view. Central banks do not want to kill the economic expansion and are sensitised to signs of credit market stress and economic weakness. Our base case remains for inflation to moderate towards targets over our 3-year horizon. Developed market 10-year bond yields are assumed to be in line with inflation 3-years from now (i.e. 0% real yields).
The combination of tighter monetary policy and the commodity shock creates a less accommodative macro environment for equities in the near-term, but the 3-year outlook remains constructive. Global equity’s expected returns are viewed as neutral and some regions above neutral after recent selloffs. Market valuations (trailing PEs) are close to/below our assumed exit or fair value PE assumptions in most regions. Earnings are projected to grow at a slower, but still decent pace, underpinned by positive economic growth. The investment horizon is crucial, as geopolitical risks, quantitative tightening and interest rate hikes are likely to cause volatility across all markets in the near-term.
The UK is expected to follow the global trajectory with a slowdown in economic growth and sticky inflation in 2022. The Bank of England is expected to raise interest rates further, alongside the global tightening cycle. London listed companies posted a strong earnings recovery in 2021, and more moderate growth is projected over the next three years.
From a medium-term valuation perspective, and under our High Conviction scenario, UK, developed and emerging market equity is at neutral. Bond yields rose sharply, and UK and US fixed income have become more attractive but expected returns remain below neutral. UK and US cash remain just below neutral. The overall (medium-term) signal is therefore equal weight equities, with an increase in allocations to fixed income and alternatives. See the table below for a summary of our Asset Class Valuation Signals.
