View From The Top: Mission accomplished?

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: Risk-on seems to be the order of the day. Some mean reversion was always going to be inevitable after 2022’s underperformance. Nonetheless, the bullish moves witnessed in almost all asset classes year-to-date might well suggest that the Fed has accomplished its mission of bringing inflation under control without provoking a major recession. The elusive soft-landing might just be possible. We certainly see a lot of evidence supportive to the idea that inflation may have peaked and could dissipate as quickly as it arrived. However, we also recognise that there is little point in Central Banks going soft on inflation now, with the battle still not fully won. We caution on investor complacency or excessive optimism, but believe that effective financial markets should be forward-looking. Much of the potential bad news (or possible valuation downside) has already been discounted, in our view. This implies that investors should be constructive in their asset allocation strategies, embracing a diverse approach to portfolio management and deploying cash unemotionally back into the market.

Asset Allocation:

• Globally, equities have staged an impressive 17%+ rally from their October 2022 trough. Most notably, emerging market equities have outperformed their developed world peers, with the MXEF Index outpacing the MXWO Index year-to-date. This trend may continue, particularly if the Dollar weakens further. Equity returns in general will likely be lower than in previous cycles, given that there are now other reasonably yielding alternatives for the first time in over a decade. In the near-term, there is the additional risk of further downgrades to earnings estimates, pressuring valuations. All the above implies the importance of active approaches to equity selection and the adoption of an approach that embraces a broad range of styles: growth and value, cyclical and defensive.

• Fixed Income/Credit: 2023 has seen the best start to a year for government bonds since 1999 (per Bloomberg), although this should perhaps not be surprising in the context of last year’s marked underperformance. What remains clear is that the investment case looks stronger than it has for some time. Yields are meaningful, even if they are already compressing, with the yield on 10-year US Treasury debt having moved from a 4.2% peak in October 2022 to 3.5% currently. Notably, for the first time since 2014, there is no negative yielding government debt globally. We counsel judicious selection, particularly within the corporate space, where owning higher quality credit is logical, in our view.
• Currencies: The US Dollar had become clearly over-bought and over-owned and has correspondingly moved down c10% from its 2022 peak. The Euro, correspondingly, is at its highest relative to the Dollar since April 2022. This trend may endure in the near-term, but we remain of the view that currencies tend to mean-revert over time.
• Gold/Commodities: The impressive move in the gold price year-to-date (up almost 6%) reflects the shift lower in real yields and a weaker Dollar. We have argued consistently that gold and commodities more generally should occupy a place in investors’ portfolios. Such assets bring clear diversification benefits.
• Alternative Assets:  The collateral-backed cashflows available for this asset class can act both as a portfolio diversifier and an inflation hedge. We favour business models with strong balance sheets, but recommend thorough due diligence.
• Cash: Although we see a continued logic in deploying cash tactically and unemotionally, we also recognise the current attractiveness of cash as a bona fide asset class for the first time in decades.

Based on the price action we’ve seen in many asset classes year to date, the answer would appear to be yes – the Fed has indeed accomplished its mission in raising rates sufficiently to tame inflationary pressures without simultaneously forcing the economy into a deep recession. Or at least that’s one interpretation. We have argued since late last year that investors should adopt a more constructive stance to allocation, reducing cash weightings. This stance remains valid although we would advocate vigilance and caution against complacency.

2023 was always likely to begin with a bounce back in asset prices given the major drawdowns witnessed in the prior 12 months. Sure, 2022 was the worst year for global equities since the collapse of Lehman Brothers in 2008, but whereas the MSCI World fell 42% that year, last year’s decline was less than half this level (-19%). This creates an interesting set up where some – including ourselves – are of the view that drawdowns represent opportunities, whereas others are of the opinion that markets need to see a major capitulation before it is time to consider adding risk. Fund Manager cash levels are at 21-year highs (per the latest Bank of America Merrill Lynch investor survey).

The latter of the above two views is, however, missing the point: the major reset in asset class valuations has already occurred, in our opinion. Forget equities for a moment and consider that last year was the worst for fixed income investors (as measured by the returns from owning 10-year US Treasury debt) in over a century. Similarly, owning a 60:40 bond-equity portfolio in 2022 would have generated investors the fourth worst annual return since 1900 (per Goldman Sachs). As a result, the yields currently available across the fixed income spectrum, but especially in ‘risk-free’ government debt, now look more attractive now than they have done for some time.

It is also to the bond market where one might want to look to consider whether or not the Fed’s mission has been accomplished. The yield on 1-year US Treasury debt is currently 4.7% while the yield on 1-year TIPS (Treasury Inflation-Protected Securities) is 2.7%. What this implies is that the market is discounting US inflation of 2.0% – the difference between these two figures – by January 2024. This is quite remarkable in the context of headline inflation in the US being over 9% as recently as June last year. Might it just be possible that inflation disappears as quickly as it arrived?

There is certainly a growing body of evidence to support such a contention. Even prior to the reopening of the Chinese economy, supply chain pressures around the world were beginning to ease. Freight shipping rates are down over 80% from their peak. A mild European winter has also resulted in lower natural gas prices (down 65% from their peak) and a similar pattern is reflected in the moves in commodities as diverse as fertiliser, wheat and lumber, all at least 30% below last year’s highs (data from Bloomberg). In the US, wage pressures have diminished with last reported wage growth the weakest since December 2020. Further grist for the mill is provided by a weakening housing market. Clearly falling shelter costs will have a major positive impact on reducing headline inflation numbers going forward.

All the above certainly makes the job of Central Banks easier. Nonetheless, Core US CPI inflation at 3.7% is still a long way from target (2.0%), not to mention Eurozone inflation at 9.2%. Credit is, however, due to the Fed in having done a good job at tightening so far without having broken anything. The European Central Bank, in not tightening, may also have (inadvertently) helped to ward off a deep Eurozone recession. Despite such progress, it is logical for Central Banks to stick to restrictive rates for now to avoid making the mistakes of the 1970s. There is no point in going soft on inflation now. The Fed in particular has too much on the line – both economically and reputationally – to do anything but keep rates high for some time.  Where there is a disconnect is that the Fed continues to suggest that we are some way from peak interest rates whereas the market (Fed Funds Futures) is already discounting a decline from June onwards. The implied Fed Futures peak of 4.9% is some below the Fed’s currently targeted peak (5.0-5.5%).

Our major concern about current market dynamics is the danger of complacency, or excess optimism, perhaps exacerbated by the lower starting point for forward returns generated by last year’s market performance. Bear markets can clearly have rallies and notwithstanding this, the direction of markets is rarely linear. We think it is therefore crucial to separate the signal from the noise.

Begin with this year’s rally in equities. Dig beneath the surface and the rebound has been driven more by moves in last year’s laggards and early cyclicals rather than being spread broadly across the market. An element of FOMO (fear of missing out) appears to have returned to some market participants. Next, consider that the current reporting season of earnings – which is only about a third done – has seen a decidedly mixed performance, with the proportion of companies beating consensus below long-term average levels. Earnings estimates for the S&P 500 Index have turned negative for the first time since January 2021, with revisions at their worst since March 2020 (all data per Bloomberg). History would suggest that margins – which are at record highs – should mean revert. Operating leverage can work on both the way down as well as the way up. Many companies currently face an unfortunate cocktail of falling sales and sticky costs.

The Fed (and other Central Banks) need to be mindful that the impact of monetary tightening takes time to play out, typically around nine months after policy implementation, per most economists. The corporate earnings outlook may, therefore, deteriorate further. At the same time, there remains the chance of a policy error. The Fed’s potential stubbornness in not cutting rates even as inflation slows might possibly exacerbate the risk of recession, thus avoiding a soft landing for the economy. This latter term is, of course, poorly defined, but may prove elusive. Perhaps it’s just too much to ask: a return to 2% inflation without a recession and with the Fed also executing a successful policy pivot. Central Banks should remain data dependent, but investors should also recognise that recession risk will be asynchronous globally.

A different view, of course, would be that maybe all the above is irrelevant. Put another way, 2023’s possible recession has to be the most widely predicted in history (or at least in the 25 years your author has worked in finance). The inversion of almost all major yield curves – the difference between short-term and long-term Treasury yields – is at its most pronounced since 1981. Such a trend is said to herald faithfully the imminence of recession. Further, some 87% of Fund Manager respondents to the latest Bank of America Merrill Lynch survey say they expect a recession in the next twelve months. However, markets are forward looking. Earnings tend to bottom six to nine before the economy does. Also consider what’s priced in. Strip out the US mega-cap tech names from the valuation of the S&P 500 Index, and the notional ‘S&P 494’ trades on just 16.0x forward earnings (per Alpine Macro), a potentially attractive entry point.

Before we get too excited, do not forget the risk of grey swans. The last few years have brought more than their fair share of negative surprises. Top of the list would be further adverse geopolitical developments or the possibility that the US Government fails to resolve its debt ceiling. Beyond these scenarios we should also consider what if, global economic growth were to slow to levels more like 2008. Alternatively, perhaps the Fed (et al) might have to do substantially more than is assumed to control inflation. How Central Banks might manage a return to secular disinflation would also be interesting. None of the above looks too likely to us at present, but it nonetheless remains the case that investors should proceed with cautious optimism. The mission is not yet accomplished, but we are on our way.

Alex Gunz, Fund Manager, Heptagon Capital