View From The Top: Buckle up

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

View from the very top: buckle up for the ride in H2. If the price action across all asset classes was not bruising enough in the first six months of the year, then the second half could bring more of the same. Investors have had few places to hide across mainstream asset classes so far this year. The good news is that after such significant drawdowns in many spaces of the market, it is now possible to approach investing with a more constructive mindset. While it is hard to time market bottoms, there is a high opportunity cost attached to not participating, especially in the event of rallies. Sure, there are the risks of policy error and recession, but as abruptly as Central Banks have sought to tighten, they may be forced to backtrack. Rather than taking a specific view on the economy, we think it more important to focus on asset allocation: stop thinking about bond-equity correlations and start thinking about the logic of increased diversification. Keep some dry powder too.

Asset Allocation:

• Equities: The 20%+ fall in the MSCI World Index year-to-date masks much of the significant damage that has been done below the surface with many equities (small caps, high-growth tech etc) down over 50% from their highs. The impending Q2 reporting season may, however, bring further downside. Earnings compression could follow the multiple compression that’s already occurred. Lower valuation starting points do at least clearly make certain segments of the market more attractive than they have been for some time, particularly for longer-term investors. We favour a balanced approach to allocation, seeking to own a combination of growth and value, quality and cyclical equities.

• Fixed Income/Credit: The performance of the Bloomberg Global Aggregate Bond Index broadly mirrors that of equities. It has seen more than a 20% decline from its January 2021 high, with over $7tr of bond value destroyed since the start of 2022 alone (and $15tr from peak). The yield on ten-year US Treasury debt is now back to 2011 levels, while two-year yields were last this high at the time of the Financial Crisis. As a result, certain bond yields can now be considered attractive relative to the (dividend) yields available from owning equities. We see some logic in exposure to longer-dated debt. On the negative side, watch for widening stress in the corporate credit market as recession risks grow.     
• Gold/commodities: We have been positive on commodities for some time and believe that adding them to portfolios should improve risk-adjusted returns. We see a case for owning a diverse basket of such assets. A backdrop of supply constraints is an additional near-term driver. Gold (and listed miners) should also benefit from their safe haven status.
• Alternative Assets:  The logic of owning hard assets is compelling, especially since collateral-backed cashflows act as an inflation hedge as well as a portfolio diversifier. Favour business models with strong balance sheets very selectively within the real estate, infrastructure and logistics spaces.
• Cash: The increasingly competitive yield on cash only increases its near-term attractions. We see a case for some allocations, particularly as a place to hide against a more uncertain macro backdrop.

If you thought the first half of 2022 had not been bruising enough, then buckle up and potentially prepare for more of the same over the next six months. What the year’s price action has demonstrated amply is just how few mainstream hiding places there have been. Further, the rate of change, or speed of decline has shocked many. Consider it almost a perfect storm given that the combined quarterly returns from owning a basket of equities and bonds (using the MSCI World and the Bloomberg Global Bond Indices as proxies) has been the worst ever dating back to the formation of this series in 1990. Markets will remain dislocated in our view, until investors are able to form a better picture of the landscape.

Our distinct sense is that markets tend to over-correct in both directions. Consider the bursting of the meme, bitcoin, crypto and ARK bubbles (to name but a few) by way of case studies. Howard Marks is almost certainly right in noting that “we never know when we’re at the bottom”. Against this background, we think it is important to be constructive rather than heroic. There is a clear danger in not participating, particularly should there be abrupt rallies. Bear markets naturally do contain them. Deploy tactically, but keep powder dry.  

In times of such heightened uncertainty, there is a natural tendency to resort to the comfort of the past. We, however, are wary of searching for precedents since the current down market is occurring in a very different era. It was always going to be challenging to believe that there wouldn’t be consequences from ending the biggest monetary and fiscal experiment in history. Further, such a marked shift is occurring in an era characterised by the twin (and interlinked) challenges of deglobalisation and inflation. These dynamics make life highly difficult not only for investors, but also, clearly, for policymakers.

The credibility of Central Banks – which have kept markets anchored ever since the end of the Financial Crisis – has been shattered by the return of inflation. Just six months ago only 2 of the 12 members of the Fed’s rate setting committee (the FOMC) thought that rates would be greater than 1% by the end of this year. Now, there is unanimous consensus among its members for rates to be at least 3%. Does this speak of ineptitude and bad forecasting, or just simply that the world has changed rapidly in a very short period of time (with war in Ukraine as an additional complicating factor)? At the least, it is a major adjustment.

The shift has also induced a state of cognitive dissonance, or the challenge of trying to reconcile two conflicting world views. In the former, inflation lies at the heart of all problems and so Central Banks across the world have no choice but to keep on tightening. However, there are almost no precedents for the Fed and its peers being able to achieve soft landings for the economy while hiking. The alternative world view, then, is that something will break (if it has not already broken) and rapidly slowing growth will force a reversal in monetary policy. We therefore face a paradoxical situation where bad news could be considered as good and vice versa. If a recession is coming, then the Fed (et al.) may have to backtrack on policy. The recent decline in 10-year US Treasury yields from their peak speaks partially to this ‘hope’. Impending mid-term elections in the US may also play an indirect role in the direction of travel for policy.

For now, however, it is hard to deny that some combination of higher rates, China’s zero-COVID policy (with corresponding lockdowns) and the ongoing conflict in Ukraine won’t  have a negative impact on global growth. While at the start of last month a recession still seemed potentially avoidable, the likelihood of one seems to be growing, particularly in the US. Recessions are, of course, notoriously difficult to forecast and one only tends to know about them in hindsight, once they have started. What we do know is that searches on Google for the term ‘recession’ are at their highest since the pandemic’s onset in March 2020. Psychology matters and recessions can easily become self-fulfilling prophecies. US consumer sentiment is at its lowest ever, per the University of Michigan’s latest survey. And it’s not just Americans who are cautious. Globally, sentiment has not been this low since 2009, per the OECD. Even Jerome Powell, the Fed Chair, has acknowledged that a recession is “certainly a possibility” – a clear case of a Central Banker using a euphemism if ever there were one.

To return to the importance of psychology, this may be the most important driver for policymaking. Everyone (consumers, businesses, investors) is behaving differently now to in the previous era of deflation. Put another way, when an inflationary psychology takes hold, policymakers have no choice but to tighten until such a mindset goes into reverse. Inflation certainly seems to be public enemy number one at present, particularly for President Biden ahead of the mid-terms. With US grocery prices rising at an annualised rate of 11.9%, everyone is affected. Headline US inflation of 8.6% is the highest since 1982 and the Atlanta Fed’s measure of ‘sticky’ inflation has not been at its current level since 1992.

Sure, it’s easy for Jerome Powell to assert that his commitment to curbing inflation is “unconditional” but the Fed’s assumption for a c2.5% level by year-end 2023 and into 2024 looks highly out of sync with the expectations polled by the University of Michigan in its latest survey. In this world view, consumers see inflation at 5.3% a year out and 3.1% on a 5-10 year horizon. We feel more comfortable with the latter set of assumptions. Even very good policymaking can’t cure supply side constraints. Further, however logical the shift to alternative energy might be, it will be very hard to achieve without introducing some structural inflation. Rebuilding (or reshoring) supply chains is also de facto inflationary.

If things look challenging for the US (and by implication the world), then spare at least a brief thought for Europe. Higher interest rates here could fissure the Eurozone. Inflation in Europe is nearly as high as in the US (8.1% last reported), but underlying economic growth is slower and the continent’s dependence on Russian energy markedly higher. Strains in the region’s debt markets evoke uncomfortable memories of the Eurozone debt crisis a decade ago. Italy currently has more debt than it did a decade prior, at the start of the previous crisis. The country’s debt to GDP ratio of over 150% (Greece has a comparable level) is more than double that of Germany’s. It’s hard to know what the European Central Bank can do to minimise the risk of widening spreads. At the same time, little speaks more of an impending sense of crisis than the convening of an emergency meeting of the Central Bank last month. This ‘grey swan’ would, however, be more than offset should the other metaphorical swan – an end to Russia’s campaign in Ukraine – hove into view. A termination of the conflict, which could occur as abruptly as it started, would undoubtedly be highly positive for risk assets.      

It’s almost platitudinous to observe that in the last two years investors have had to rethink almost all their asset allocation assumptions. However, what should be abundantly clear is that the logic for a 60-40 portfolio allocation across equities and bonds is over. Investors need to stop thinking about bond-equity correlations and start thinking about the logic of diversification. Disillusionment is only natural in such trying market conditions, but this state is very different to one of capitulation. We haven’t seen evidence of the latter yet. Our counsel is to remain constructive; not to panic and to allocate tactically to discrete opportunities.     

Alex Gunz, Fund Manager, Heptagon Capital