View From The Top: On walls, fear and simplicity

View from the very top: The 60-40 portfolio is back. Despite overwhelmingly sceptical and bearish investor sentiment, equity markets are higher and global bond yields lower than they were six months ago. Uncertainty may be at elevated levels with a credit crunch, rolling banking sector crises and a recession all but inevitable. However, there are two arguably more important factors to consider: the extent to which the bad news is already discounted and the direction of monetary policy (towards a looser bias). Do not forget, the major valuation reset has already occurred, especially in the fixed income space. Intuitively, the best time to be allocating new capital should be at precisely the moment when sentiment is not riding high. Have no doubt, the way forward will not be linear. Our counsel is, therefore, to keep things simple. We see a case for being constructive on both fixed income and equities although it is important to adopt an active approach across all asset classes. Markets, we believe, will continue to exhibit a tendency to climb walls of worry.  

Asset Allocation:

• Equities:The strong rally exhibited by global equities since their October 2022 lows continued into April. We have been reassured by the robustness of corporate earnings exhibited in the current reporting season to-date. We believe that investors seem increasingly to be discounting not only the likelihood of recession but also the prospect of lower interest rates. Such an environment would be conducive to longer duration assets and also be helpful for emerging market equities relative to their developed world counterparts. We favour balance across styles: growth and value, cyclical and defensive. Use drawdowns as potential opportunities.
• Fixed Income/Credit: Peak inflation logically means peak bond yields, in our view. The case for owning fixed income is also supported by the major reset that has already occurred in world government bond market valuations. Lower interest rates would inevitably be supportive for bond yields. It is also noteworthy that despite turmoil in the financial services sector, both March and April saw over $100bn of Investment Grade credit issuance, comparable to levels of a year prior (per Bloomberg). While positive, choose carefully within the credit space, particularly across corporate debt.
• Currencies: With the Federal Reserve getting close to the end of its rate hiking cycle, the US Dollar has already begun to weaken, reaching a 7-month low in the past month. For context, the Dollar did mark a 20-year high last year and our contention has always been that currencies will have a tendency towards mean reversion. A weaker Dollar is inevitably positive for emerging markets. For safe haven status, watch the Swiss Franc, at new relative highs.
• Gold: The notable (~20%) gains in gold in the last six months could continue in our view. The precious metal will benefit from a combination of lower bond yields, a weaker Dollar and ongoing geopolitical uncertainties. Central Banks are buying the metal at levels not seen since the late 1960s (per the World Gold Council) and many investors remain underweight.  
• Cash: Money market funds have been an inevitable beneficiary of financial uncertainty in the US. We recognise that cash comprises a bona fide asset class for the first time in decades but also see a continued case for tactical and unemotional deployment into other undervalued areas of the market.
• Alternative Assets:  It is important to be selective in this broad and diverse area. We are attracted to business models with good visibility, typically in the form of strong balance sheets and collateral-backed cashflows, but recommend thorough due diligence. The lagged impact of higher interest rates may impact certain areas. Within US commercial real estate, we note that over $1tr of debt will need to be refinanced over the next two years (per Morgan Stanley).

Whisper it, shout about it or just simply acknowledge it: the 60:40 portfolio is back. Global equities are up 20.8% from their October 2022 low and 9.5% higher year-to-date (per the MSCI World), while the yield on US 10-year Treasuries has dropped to 3.5% from a peak of 4.2% six months ago. Despite these enviable returns, investors remain deeply sceptical about the outlook. Concerns range from recession risk to credit crunch not to mention the possible downside to corporate earnings revisions; and that’s before we’ve even begun to contemplate geopolitics. Herein lies the opportunity. It is our contention that despite fearfulness, markets will continue to climb the perceived wall of worry. Use this uncertainty as time to deploy cash but keep it simple and don’t over-complicate things.

Have no doubt, forecasting has rarely been harder. By way of quantification, consider that the range of consensus analyst expectations for 2023 US GDP growth is double 2019 levels (per Bloomberg). For another data point, read the latest outlook report from the IMF. The word “uncertainty” appears almost 60 times in this document, more than two times the number of a year prior. The explanation for such amplified doubts is not difficult to find. Two exogenous supply side shocks (the pandemic and the invasion of Ukraine) provoked the fastest rate of monetary policy tightening in a generation. Prior to this, investors endured over a decade of monetary experimentation via quantitative easing and more. Against this background, the collapse of Silicon Valley Bank (SVB) may have set a precedent. Think of it as potentially one of a series of rolling mini crises – a function of adjusting to the new world of monetary policy. Economic change never happens smoothly. First Republic is the latest example of the phenomenon.

If we begin from here, it seems only reasonable to assume SVB’s failure will heighten pre-existing wariness among investors and lenders. The Bank of International Settlements talked in its latest report of “increased stress in the system” from years of easy policy followed by rapid tightening. Read the Bank of America Merrill Lynch monthly Fund Manager Survey and the leading concern cited by investors is credit squeeze followed by global recession. The survey suggests that sentiment is the weakest since the Great Financial Crisis. Bloomberg corroborates this view, pointing to cash levels at record highs and bullish sentiment at a 30-year low.

Despite such overwhelming scepticism, equity markets continue to climb higher. In case you missed it, the first quarter of the year was the best for the S&P 500 Index since 1998. The NASDAQ Index performed even better. Further, the VIX Index of volatility is the least elevated it has been in over two years. We detect a certain irony: the more markets go up, the less investors seem to trust them. In situations such as these we defer to the wise words of President Roosevelt, uttered in the Great Depression (when allocation decisions would surely have been harder): “the only thing we have to fear, is fear itself.” Logical and clear-headed thinking would suggest that surely the best time to invest is when sentiment is not riding high.

How might we solve the conundrum of fearful investors but higher markets? Keep it simple: markets are forward looking. What matters is what happens relative to what is already priced in. Put another way, the obvious is usually well-discounted. Let’s also not forget that the big valuation reset has already happened. Fixed income (measured by the return on 10-Year US Treasuries) experienced in 2022 its worst return in over a century. We are not surprised to see the 3-month/10-year yield curve more inverted than it has ever been (per Bloomberg). What this suggests to us is that the bond market is expecting not only a recession but also imminent rate cuts.

The pending recession has to be the most predicted, discussed and discounted in history. There is growing evidence to suggest that the dents in the global economy are becoming more visible. Even if the immediate panic from turmoil in the banking sector is over, the tightening of credit conditions will last for longer. Already, in the US, small business confidence is at its lowest in 11 years, office real estate vacancies are at record highs and foreclosures are up over 20% versus a year prior. US factory production has fallen for the first time in 12 months while the Institute of Supply Management’s latest release shows its manufacturing index at its weakest since the onset of the pandemic. US consumer confidence has not been so poor in nine months (all data from Bloomberg). While unemployment figures remain low, these data points tend to be the last lagging indicator that a recession is underway. Even if economic data from China is markedly more encouraging, the IMF describes the world economy as being in a “tricky phase”, with its five-year rolling outlook for global economic growth at its weakest in over two decades.

Take a step back though and consider this challenge through a different lens. Keep it simple too. It’s all about the direction of travel for liquidity. The fact that over $1tr of Central Bank liquidity has been injected into the global financial system since the UK’s pension crisis last September (per CrossBorder Capital in the Financial Times) surely provides the best explanation for why global equities bottomed and Treasury yields peaked shortly after. A de facto pause in quantitative tightening and a similar resumption of quantitative easing in the US since SVB has also clearly been helpful. Investors might be discounting an 90%+ chance of another Fed hike in May, to 5.0%, but consensus sees US interest rates at 4.6% by year-end (per Bloomberg). Follow the money.  

The Fed’s job is certainly made easier by the fact that inflation seems to have peaked, even if it remains a long way above comfort levels. The last Consumer Price Index data show US inflation at its weakest since May 2021. With leading indicators such as new rental agreements rolling over, this is helpful for future (lower) inflation prints. For the Fed, perhaps the bigger challenge now is to avoid over-tightening. Too tight for too long may only increase the odds of a deeper recession. Arguably, failures in the banking sector are suggestive of the fact that the Central Bank has already tightened too far.

Imagine a scenario then, where lower interest rates reduce borrowing costs. At the same time, less inflation implies less pressure on input costs. Equally, higher unemployment keeps labour market costs under control. All the above implies that the downside risk to corporate earnings could be relatively limited. The current earnings season has also been markedly less bad than feared, with the percentage of US companies positively surprising relative to expectations above pre-pandemic average levels (77% vs 73%, per Bloomberg). Factset data suggest quarterly consensus estimates will show an improvement as 2023 develops. The above reinforces the point that markets are anticipatory. A recession is broadly discounted (in our view). As importantly, easier monetary policy is good for longer duration assets. Forget the fear, climb the wall and keep it simple.

Alex Gunz, Fund Manager, Heptagon Capital