View From The Top: The Game Is 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.

Years of unconventional monetary policy followed by the fastest pace of interest rate hikes in a generation were always going to have consequences. Something had to break – and it did in March. While sentiment remains febrile, the more important dynamic is that financial markets believe the game is up. The era of monetary tightening is over, regardless of what Central Bankers may assert. Sure, the fight versus inflation pales into insignificance next to the stability of the banking system, and while we should reasonably expect to see more financial casualties and potential bail-outs, we believe it is possible to chart a constructive path forward based around lower inflation and lower interest rates. This would naturally be supportive for longer duration assets. It may, of course, not be possible to avoid a recession. Against this background, we counsel pragmatism and balance across portfolios, but also recognise that from crisis, opportunity almost always emerges.    

Asset Allocation:

• Equities: The MSCI World Index has now risen for two consecutive quarters and is almost 18% above its October 2022 low. This move has come despite downgrades to consensus earnings estimates (down 8% from peak, per Bloomberg) and the growing risks of a recession. We believe two interlinked factors are behind this dynamic. Investors are forward-looking and seem willing to pay up for growth in a world where it is looking increasingly scarce. More optimistically, if inflation weakens, then not only bond yields, but also equity market multiple compression should reverse. From an allocation perspective, we favour high-conviction active managers across a broad range of styles: growth and value, cyclical and defensive.
• Fixed Income/Credit: We believe that the major reset in developed world government bond market valuations in 2022 creates a significant opportunity for long duration assets. If the game is up for Central Banks (especially the Federal Reserve) and the path for interest rates correspondingly lower, this should be highly supportive for bond prices. At the same time, we see a reduced logic for high yield and financial credit in the context of currently tighter financial conditions and stricter lending standards. We counsel judicious selection, particularly within the corporate space.
• Currencies: The US Dollar should weaken further from current levels if our thesis about potentially easier monetary policy from the Federal Reserve plays out. Put another way, the faster the US economy cools, the weaker should be the Dollar. The Euro may correspondingly benefit. Over time, however, we believe currencies tend to mean revert.
• Gold: A higher gold price is another output of expectations for lower US interest rates. We have long advocated a case for gold (and gold miners) in investors’ portfolios given the asset’s defensive qualities and diversification benefits. Commodities also bring some diversification but may be constrained in the event of a weaker global economy.
• 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. Pockets of commercial real estate would clearly be at risk from tighter financial conditions.
• 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.

The world of finance is rarely dull, but March 2023 will surely count as one of the most turbulent months in recent times. With hindsight, March’s madness had an air of inevitability to it. We have long argued that years of unconventional monetary policy deployment were always going to have consequences. The massive moral hazard induced by quantitative easing was replaced by the fastest pace of interest rate hikes in a generation. Something would have to break. As bank failures on both sides of the Atlantic clearly showed, the game is up.

The game is up in another clear respect too. Markets do not believe Central Banks, especially the Federal Reserve. Despite their rhetoric (not to mention still stubbornly high inflation), Fed Futures rates are already beginning to discount interest rate cuts. Even if investor hunger for rate cuts currently seems to be trumping fears of recession, the era of tighter monetary policy seems to be over for now.

Interest rates have always been a blunt monetary policy tool, in our view. However, history may well show that the Federal Reserve acted too late and too fast with its approach to managing inflation. Sure, it would have been hard to model the impact that first the COVID-19 pandemic and then Russia’s invasion of Ukraine would have on financial planning, but it seems possible that the Fed may have misread transitory inflation – driven by exogenous supply side factors – to be incorrectly permanent, and so acted accordingly.

It is also somewhat disingenuous, we believe, to argue for the ‘separation principle’ that seems to be guiding Central Bank policy at present. Under this logic, interest rates are the mechanism used for managing inflation, whereas direct intervention (via the recent Bank Term Funding Programme, or BTFP) serves to help stabilise the system and fend off a potential banking sector crisis. However, dig deeper and the neat division between monetary policy and financial stability tools is not so clear. The quantitative tightening embarked upon by the Fed last year to tame inflation has been effectively abandoned, whereas since the BTFP was initiated, the Fed’s balance sheet has grown by $300bn. Put another way, two-thirds of the Fed’s balance sheet reduction from ‘peak QE’ in April 2022 has been unwound in less than three weeks (per Bloomberg). Think of the policy as being quantitative easing in all but name. The game is up.

Perhaps the more important question to consider might be why policies such as the BTFP are necessary. This can be characterised by the fact that a major crisis in the banking sector will suck liquidity out of the economy. Banks are naturally more reluctant to lend than they were a month ago. In the absence of liquidity, the risks of recession are proportionately much higher. This logic also explains why the futures market is now discounting US interest rate cuts from as early as June. At the start of March, US interest rates were forecast to peak at 5.7% in June and be at 4.8% by year-end. In a quite remarkable volte-face, peak rates are now seen at 5.0%, with a December 31^st rate of 4.4% (all data per Bloomberg). The yield curve is also highly inverted. A similar pattern can be seen at work in other geographies too.

Listen to the Fed though and the message is quite different. “Rate cuts are not our base case” said Jerome Powell in the press conference held after the Fed hiked for the ninth consecutive time in March. While the logic for persisting with rate increases is intellectually sound – inflation remains at three times the Fed’s preferred rate – we cannot help but wonder whether Powell’s decision may come to be seen as a ‘Trichet moment.’ As a reminder, the then-governor of the European Central Bank (Jean-Claude Trichet) hiked rates on the eve of the Great Financial Crisis. Perhaps the game is up for Powell. Credit market spreads moved after the Fed’s latest press conference to the widest level seen since December 2007. Credibility is hard-won but can be easily lost.

It seems clear that financial markets have entered a new phase. The Fed’s aggressive tightening cycle has started to bite, evidenced by the banking crises witnessed in March. Sure, monetary policy should be data-dependent rather than ‘bank-dependent’ but it is fair to recognise that the fight versus inflation pales into insignificance next to the stability of the banking system. At the same time, it is possible that recent events will also help squeeze inflation out of the system. Lenders are now more nervous and businesses more risk averse than a month prior.     

On this basis, allowing Silicon Valley Bank to fail may perhaps have been logical – if it has the desired impact of reducing broader market risk appetite and de facto bringing about tighter financial conditions. However, if history provides any guide, we should be prepared for more shocks to the financial system and the growing eventuality of recession. Forget a ‘soft landing.’ Rather, we are witnessing the accumulating process of a credit crunch. A deeply inverted yield curve naturally generates huge pressures across the financial system. These are compounded by the moral hazard that has accumulated from over a decade of very loose policy. Monetary policy always works with a lag and we should expect to see more casualties. The first bailout package in any crisis is rarely the last. At least, the word contagion is only being uttered very quietly at present.

Where might other risks lie? A logical response would be to consider any areas of the financial ecosystem which are heavily levered and subject to changes in interest rates. Commercial real estate and non-marked-to-market private equity might be obvious candidates. Systemic credit risk is seen as the number-one concern for investors at present (per Bank of America Merrill Lynch’s latest monthly Fund Manager survey). Logically this argues for systemic stabilisation. But there are no easy options if you’re either a Central Banker or a politician. Damned if you do and damned if you don’t. Forget inflation for a moment. Financial implosion is a sign that the Fed has tightened too much rather than too little.

In terms of what happens next, it’s important to keep some perspective. This is not a replay of 2008, we sense. The root cause is very different. Whereas the GFC was a function of bad loans, the 2023 debacle stems from the Fed’s rapid tightening. This is a liquidity crisis, not a credit crisis. Next, capital returns are higher and consumer balance sheets more robust. Regulators also have more power to stem off issues in the banking sector, as recent events have evidenced. Finally, Central Banks also have more flexibility, given the relatively elevated level of interest rates currently. The scope for cuts (not to mention any form of stealth QE) could serve to reduce systemic pressures. In a fiat system, there is effectively no crisis that cannot be tempered through monetary manipulation.

Amidst all the bank angst, it is notable how robust equities globally have been. The MSCI World is up over 7% year-to-date and has risen more than 17% from its October 2022 low (the figures for the NASDAQ Index are notably higher). This outcome has been achieved despite the fact that Financials comprise the second-largest sector of the MSCI World, with a 14.6% weight. Admittedly, the large (21.3%) weight of the tech sector – a laggard last year and relatively insulated from the current crisis – has helped, but perhaps the best explanation is that investors are simply not buying the Fed’s narrative. The fall in the 10-year YS Treasury yield in the past month (from 3.9% to 3.5%) is the starkest indicator that the game is up. Markets are forward-looking. The eventual path is towards lower interest rates and easier financial conditions, helpful to longer-duration assets.

If we have a concern, then it is simply over-complacency. Experience has taught us that markets are highly non-linear. Beyond this being a sui generis market cycle where both policymakers and asset allocators have only a limited playbook on which to draw, the impact of a recession on earnings estimates should clearly not be underrated. Casualties elsewhere in the system would also heavily dent risk appetite. Abrupt tightening without (more) things breaking is just too optimistic an expectation. Things may then get worse before they get better in the near-term. At the same time, however, it is possible to chart a constructive path forward based around lower inflation and lower rates. As defensible as a flight to safety in times of profound uncertainty seems, we also counsel a degree of pragmatism. Keep balance across portfolio. Recognise that from crisis, opportunity almost always emerges.  

Alex Gunz, Fund Manager, Heptagon Capital