A decade of near-zero interest rates pushed asset prices higher, but the resurgence of inflation, high unemployment and the reopening after the pandemic has forced central banks to raise rates and this has brought about a sea change in financial markets.
This is starting to be seen in the real economy, with higher mortgage rates constraining household income, weakness in manufacturing and slipping operating margins. This creates a risk of earnings downgrades in the remainder of 2023, putting pressure on equity market valuations.
Brooks Macdonald senior investment director David Appleton says: "We know there will be headwinds to economic activity from higher interest rates, but we don't know how quickly that comes through.
"We have seen a sharp re-pricing of assets to reflect higher interest rates. While we know there's negative economic activity coming down the track, valuations have moved already. The question is how much is priced in?"
Head of risk-managed funds Hector Kilpatrick attributes the recent strength in financial markets to three main causes: the strength of the US consumer; energy prices coming in lower than expected; and China's reopening.
"We are in a phoney war, where recession has yet to show itself," he says. Kilpatrick believes unemployment needs to rise before inflation can be squeezed out of the system.
Last year's movement in markets has opened up the opportunity set for investors, particularly in fixed income.
Appleton says: "Fixed income has repriced more aggressively than anyone was anticipating. We think it's very attractive. However, we're quite cautious on our outlook for the economy and therefore have some concerns on corporate high yield. In contrast, investment grade is quite resilient and should be able to trade through it. Financial debt and bank debt in particular."
The group also has inflation-linked government bonds for the first time in a decade. More widely Appleton believes governments bonds can act as good risk-off defensive hedge once again.
Geographic diversification is important at a time of deglobalisation, but it is vital to look not where a company is listed, but where its exposure lies.
He explains: "A lot of UK companies are very international. They are global leaders in their field and earn profits all of the world. We want to understand their real underlying exposure."
Appleton adds that investors have done well from international diversification in recent years because sterling has done so well. However, he says "it's just a risk like any other".
Elsewhere, the group holds a wide range of alternatives, including infrastructure and renewable energy, but believes private equity looks vulnerable to higher interest rates. Kilpatrick sees greater opportunity for absolute return managers to add value as investors focus more on fundamentals.
In this volatile and uncertain environment, having an unconstrained approach is vital.
Appleton says: "Even though economic outlook isn't great, the multi-asset opportunity set is better than it has been for some time."
