The Great Rebalancing Act

By Mark Azzopardi, Executive Director at Jesmond Mizzi Financial Advisors

The headlines this year have been dominated by rising inflation and the cost of living crisis that has developed as a result. How has this affected financial markets?

We started the year with inflation continuing to rise mainly as a result of economies reopening after COVID-19. In a sense, it was the healthy type of inflation because it was related to growth.

What we’re seeing now, with the war, is inflation driven by crises in sectors like energy and food. They are both primary raw inputs that are crucial to everything we do, which is why inflation in this case has translated into a cost-of-living crisis. It has been fully transmitted to the real economy.

This has in turn caused central banks to increase interest rates in order to rein in inflation by reducing the money supply dealing yet another blow to markets.

How has your strategy changed as a result of the current economic climate?

We’ve basically had to turn our strategy on its head and shift to a more defensive approach which aims to minimise risk as much as possible.

Since we expected inflation to be a significant factor in 2022, we were looking at cyclical stocks, the performance of which tends to mirror the general health of the economy – companies with a strategic advantage that have the power to push any inflationary cost onto consumers and which tend to benefit from interest rate increases.

We were also looking at companies that had potential and which stood to gain from the resumption of normal life in a post-pandemic period.

But everything changed with the war and the interest rate hikes which followed. We had to completely rethink our strategy and shift to a more defensive stance with the aim of preserving capital.

That said, some opportunities have emerged, and we’ve still managed to lock in some very attractive yields.

For example, there was a time when you couldn’t buy a bond maturing in, say, five years that would give you a positive yield. Ever since March, these bonds have become very attractive because they can be bought below par and also give investors a decent yield.

And what if interest rates continue to go up?

If interest rates increase more than we expect, bonds maturing in the immediate term will simply be reinvested at a higher interest rate in a couple of months’ time.

The bottom line is that if you don’t invest your money and keep it locked away, inflation is going to constantly eat away at it. You are losing more by doing nothing than you risk by investing in the short-term, because with an investment at least you receive an income.

All you risk is the fair value movement, which is only really a concern if you need the cash and decide to sell it before it reaches maturity.

Bond fair value movement is currently the largest contributor to lower valuations in our strategy because bonds are trading below par.

So yes, you are losing if you sell today, but really and truly if you hold it to maturity, it will have recovered, and you’d have gotten an annual yield. It might not be a huge amount, but it’s enough to offer a good cushion against inflation.

An interesting observation about our portfolio at the moment is that although we aren’t seeing much capital appreciation and though market value is down, income has increased.

At the end of the day your capital remains there, intact. It’s the secondary market, so to speak, which is below fair value.

It’s a bit like owning a shop. The value of the property might go up or down, but that is of little concern to the shopkeeper who is seeing yearly profit and has no intention of selling the property.

With this in mind, what we’ve essentially done with the bond component of our portfolio is improve the credit quality – so shifting to investment grade bonds with a high yield – as well as increase the number of short-term bonds, without selling any of the long-term bonds.

What about equities?

Our immediate reaction to the Ukraine invasion was to shift our equity exposure away from Europe and towards markets that were more shielded from the immediate impacts of the war like the US market.

We also bought equities in emerging markets like Latin America, where we saw an increase in raw material and energy exports. We were able to sell our positions a month or so later and took a healthy profit from it.

So, without reducing our exposure too much, we changed the allocation to reduce downside risk and in fact, our equity component fell less when compared to the market.

We actually realised all-time high gains on some positions in sectors like telecommunications and healthcare.

What about companies with significant future growth potential? Would you say that now is the time to jump on board?

We are avoiding high growth companies at the moment, mainly because the likelihood is that in most cases, you’ll be able to buy them at a cheaper price later on.

There are many companies that are still in their early stages of growth, and which will probably be hit harder by the present downturn. Despite this, there are companies, which have significant growth potential further down the line, in about ten years or so.

That is stock that one is better off buying towards the end of an economic downturn once conditions return for them to take off. But we’re not there yet and now is a time for a defensive approach.

How do you see the situation developing going forward?

I think uncertainty will remain for the time being mainly because it is nearly impossible to predict how the war will end.

As a company we base many of our decisions on data and not just speculation about which company’s prospects are best. We are constantly looking at many economic indicators like inflation, PMIs, Money Supply the Bare Necessities Index etc to assess market developments.

Much will depend on inflation and how quickly central banks can bring it under control. At the moment, we’re actually seeing inflation shift slightly downwards though it isn’t yet under control.

If it were to be reined in, there will be a significant positive reaction across the markets.

A lot will also depend on whether economies fall into recession and how central banks react to this. It is possible that once this happens, central banks’ monetary policy will once again shift and become more conducive to growth.

What is certain is that as portfolio managers we will continue to hoard some cash and short-term bonds as part of our asset allocation so that we can act quickly when opportunities arise.


This interview does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA under the Investment Services Act and is a Member of the Malta Stock Exchange and a member of the Atlas Group. For further information, contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta on Tel: 2122 4410, or email [email protected]