How To Prepare For A Year More Uncertain Than The Last

How To Prepare For A Year More Uncertain Than The Last
Stéphane Renevier, CFA

about 2 years ago5 mins

  • The most likely scenario for next year is to see moderate growth and inflation, it’s also widely priced in by the markets

  • But two other scenarios could be disruptive and lead to sharp price moves.

  • To position your portfolio for this uncertainty, you could build a balanced portfolio, use a core-satellite approach, implement long-short trades, or wait for better opportunities to present themselves.

The most likely scenario for next year is to see moderate growth and inflation, it’s also widely priced in by the markets

But two other scenarios could be disruptive and lead to sharp price moves.

To position your portfolio for this uncertainty, you could build a balanced portfolio, use a core-satellite approach, implement long-short trades, or wait for better opportunities to present themselves.

Let’s face it, no one knows what the economic environment will look like in 2022 – and risking all your hard-earned money when there are so many unknowns isn’t the smartest of moves. Your best strategy, then, might be to follow Howard Marks’ guidance: “You can’t forecast, but you can prepare.” Here are the three scenarios you could be up against next year, and how to prepare for them all.

What’s the most likely scenario?

The main macroeconomic scenario that markets are pricing in – and the reason stocks have performed so well lately – is the following “base case”: growth remains robust but decelerates, and inflation remains above average but isn’t high enough to warrant the Fed stepping in. Monetary support, meanwhile, is gradually faded out in line with market expectations.

What would it mean for your investments?

As long as the Fed has markets’ back and doesn’t push interest rates higher, there’ll be demand for risky assets. Stocks should go higher, but perhaps not by as much as they have done recently: earnings might grow more slowly, after all, and higher rates would likely lead to slightly lower valuation multiples. Corporate bonds should still do well in this environment, but government bonds might come under pressure as yields rise across the globe. And while gold could suffer from higher real yields, energy and industrial metals should continue to perform well.

What will support stock prices going forward? Source: Fidelity
What will support stock prices going forward? Source: Fidelity

What’s the best-case scenario?

If supply-side constraints ease and supply rises to meet a strong demand, inflation pressures could fade at the same time as growth accelerates. In this “Goldilocks” environment, the probability of a “Fed mistake” (i.e. raising rates so abruptly that it kills growth) would be reduced and markets would likely go back to full risk-on mode.

What would it mean for your investments?

An environment of higher growth and lower inflation is the best case for risky assets like stocks, corporate bonds, and alternative assets like private equity. It would also be positive for emerging markets’ currencies, which could rebound sharply versus the US dollar. Government bonds and gold are likely to be the biggest casualties in this scenario.

What’s the worst-case scenario?

If inflation rises further or stays high for longer, the Fed will be forced to hike rates faster and more significantly than investors are currently expecting. Higher inflation would threaten companies’ profit margins, and much higher interest rates would lead to both lower valuations (as the discount rate used to calculate future cash flows rises) and a deterioration in sentiment, pushing investors to take their profits and dump risky assets. Lower growth accompanied by higher inflation would be the worst-case scenario for risky assets, and probably for your portfolio too.

What would it mean for your investments?

Stocks are likely to be hit really hard in this scenario, with the combination of lower earnings growth, lower profit margins, and falling valuation multiples all compounding losses. Worse, bonds are unlikely to be a good hedge in this scenario and could be hit as hard as stocks. The only assets that could potentially survive such a scenario are gold and treasury inflation-protected securities (TIPS), which would benefit from higher inflation and “safe haven” investments. The US dollar and safe haven currencies like the Swiss Franc and Japanese yen might be other winners, particularly versus emerging market currencies. Bitcoin is a wildcard: it could be supported because investors are worried about the debasement of currencies, but could be hurt as investors de-risk their portfolios.

So how could you position your portfolio for 2022?

First, you could build a “balanced” portfolio – one that’s unlikely to suffer large losses if the future deviates from the base case. Such a portfolio should be split equally across stocks (good for high growth, low inflation), gold (good for low growth, high inflation), commodities (good for high growth, high inflation), and potentially cryptocurrencies (good for extremely high inflation). If you think a low-growth and low-inflation scenario is likely, you could also consider allocating some of your funds to government bonds.

Second, you could use a “core-satellite" approach, where you position the core of your portfolio for the base-case scenario and then use options to bet on the alternative scenarios. You could, for example, hedge the downside by buying cheap out-of-the-money put options on stocks and bond indexes, or buy call options on gold. To participate in the upside, you could buy call options on stock indexes. That way, your overall downside should be limited while your upside is retained. The disadvantage is that the premium you’ll pay for this optionality will reduce your returns if the base case scenario does end up happening.

For more experienced investors, there’s a third option. An uncertain macro environment should be good for investors who can generate “alpha” - i.e. returns that are not influenced by the general direction of markets. One way to profit from your active views is to implement long-short trades, effectively betting on the “spread” between two assets rather than on whether an asset will move up or down. So if you believe certain sectors or securities are undervalued, you could buy those sectors and short the rest of the market.

And last but not least, a smart way to prepare for the year is to keep some cash as dry powder and wait for better opportunities to present themselves. The best investors know to be patient and strike aggressively when the odds are in their favor.

Whatever you end up doing, make sure you have a plan to deal with uncertainty. Because if one thing is certain, 2022 will have plenty of that to go around.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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