View From The Top: The long and winding road

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: Focus on the bigger picture and lean in opportunistically. We caution against over-extrapolation from single data points and believe that the debate about the nature of any landing (soft, hard or non-existent) is misleading. From our perspective, even if investors will have to accept the reality of higher US interest rates for longer, disinflationary trends are intact, near-term earnings volatility may dissipate and the Federal Reserve, by being data dependent, retains significant flexibility within its mandate. Sure, we should expect more near-term volatility, but remember that what happens in the real economy and how investors respond through their asset allocation decisions are two different things. Markets, by their nature, are forward-looking and so should therefore bottom at an earlier stage. Do not, however, forget about escalating international tensions and the uncertainty these may engender. With all the above in mind, we call for balance in asset allocation; a judicious and emotionless approach to capital deployment across a range of styles.

Asset Allocation:

• Equities: A period of consolidation in equities may be necessary after a 20%+ rise in the MSCI World from its mid-October low through to its early February high. The corporate earnings season has also been mixed, with Factset estimates lower now than a quarter prior, most notably in the US. It’s important to nuance these dynamics, with some sectors (especially technology) having had a disproportionately negative effect and European businesses generally delivering better overall results than their US counterparts. The recent pullback in equities may create an opportunity especially for those who missed the last rally. 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: Similar to the story in equities, after the best start to a year for government bonds since 1999 in January, February saw a reversal. The biggest change in the past month has been the climb in yields, with 10-year US Treasury debt now offering 3.9%, versus 3.4% at the start of the prior month. For context, current yields remain below last year’s 4.2% peak. We believe that the promise of yield – even if it may compress – creates a potentially interesting investment opportunity. We counsel judicious selection, particularly within the corporate space, where owning higher quality credit is logical, in our view.
• Currencies: The US Dollar has enjoyed a strengthening in the past month, consistent with the view that US rates will likely remain higher for longer. Our sense remains that the Dollar is still over-owned and that most currencies tend to mean-revert over time.
• Gold/Commodities: A weaker gold price on the back of higher real yields creates a potential opportunity. We see a logic for gold (and commodities) in investors’ portfolios given defensive qualities and 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 equivalents as a bona fide asset class for the first time in decades, given potential yields.

No one ever said it was going to be easy. The strong rally in equities from their mid-October lows, accompanied by a corresponding retrenchment in bond yields, perhaps created a false sense of security. Sure, inflation may have peaked, but we have always believed the path forward would not be linear; think of it more as a long and winding road. It’s the direction of travel that matters and we stick with the view that most risk assets should be higher by year-end than they are currently. If anything, we should consider it healthy that the perceived FOMO (fear of missing out) that characterised market sentiment at the start of the year has now mostly dissipated. This creates an environment where there are clear opportunities for longer-term investors.

Relative to a month prior, the biggest change is the perception that (US) interest rates will stay higher for longer. No pivot is coming any time soon. Correspondingly, investors appear to be acting on a similar playbook relative to that of a year ago. In other words, February has been characterised by a significant increase in bond yields, with the US 10-year now yielding 3.9% versus 3.4% at the end of January. Equities have fallen. Notably, this move in yields has come despite the ongoing war in Ukraine and an increasingly belligerent tone from Vladimir Putin. International tensions are arguably at their highest level in decades, yet investors arguably seem more scared of Powell than Putin.

Jerome Powell, the Fed Chair, has always said that it will continue to be data-dependent in its approach to managing monetary policy. The ‘hope’is that the economy can remain resilient, even if rates increase. Resilience is an important theme that investors should consider more generally. The US economy, to-date, has proven resilient despite calls for recession. Recent data support the idea of robust consumer spending in particular. Markets have also been broadly resilient to bad news, as evidenced by the fact that in the 12 months since Russian tanks first rolled into Ukraine, gold is down just 6.4%, while the MSCI World has fallen only 7.6%.

The best explanation we can see for this relative robustness is that investors are forward looking by nature. Put another way, we see scope for the market to get more comfortable around the idea of higher terminal rates combined with the growing possibility that the economy may avoid a recession, or at the least, a deep one. Nonetheless, given this period of profound uncertainty, we believe that adopting a balanced approach to asset allocation matters.

For important context, we have regularly cautioned not to read too much into single data points, especially should they present a potentially conflicting narrative. The fact that core consumer inflation (CPI) has risen for two consecutive months in the US at the same time that input prices (PPI) are growing for the first time since June 2022 and retail spend is accelerating may partially be the result of an explanation as simple as the fact that recent weather in the US has been unseasonably warm; people are out and about spending – surely a good thing. We also believe it important to recognise that the term ‘landing’ – whether hard, soft or non-existent – is a convenient journalistic catchphrase, but has no formally recognised definition and so may be misleading.

From our perspective, three key things matter. First, the job of the Fed is not to ‘land’ the economy per se, but to control inflation and unemployment. There is clearly no point in the Fed giving up its fight to control inflation this far into the process. Next, we should expect more near-term volatility. The impacts of monetary policy tightening lag the event itself and so can be long and variable. This also explains why investors will naturally tend to over-extrapolate from near-term data points. Finally, do not forget, the real economy and the stock/bond market are two different things. The latter almost always reach a turning point before the former.

Bigger picture, it is logical that inflation should be falling over time, given improving supply chains and the reopening of China. Further, there will also be a significant positive impact from falling rent prices. Remember, shelter has a 43% weight in the calculation of CPI. Nonetheless, a still-tight US labour market will continue to exert upward pressure on wages and thus on inflation. Therein lies the challenge: even if it continues to fall, inflation is unlikely to get back to 2% levels any time soon. The market has, however, done an effective job in (reluctantly) accepting the likelihood of higher inflation – and rates – for longer. Relative to a month prior, bond markets are now discounting a 5.4% peak for US rates in July (it was 4.9% at the start of February) and a year-end rate of 5.2% (against 4.0% previously).

Even with this repricing, it remains a legitimate concern to worry over the possibility of inflation expectations becoming unanchored. Inflation is still the number-one risk for investors, per the latest Fund Manager survey from Bank of America Merrill Lynch. For now, this risk remains under control. One year out, the University of Michigan’s latest survey shows US expectations at 4.2%, and on a five-to-ten year view, the figure drops to 2.9%.

Where else may investors be concerned? We do not think the risk of a recession is being under-stated. Sure, signals are mixed and may have been distorted since the start of this year by as previously highlighted mild weather, but we note that both the IMF and the OECD have raised their forecasts for global economic growth relative to three months prior. The former organisation upgraded its forecast in February for the first time in a year, pointing to “a turning point for the global economy.” Ironically, if anything, current economic strength complicates the task for Central Banks, who might prefer to see signs of the economy cooling off.

However, it’s hard to deny that corporate earnings trends are weakening despite what may be happening in the economy. The recent US earnings season was one of the ten worst in the last decade, as measured by the magnitude of average estimate downgrades (per Factset). Nonetheless, even these figures are distorted by the disproportionately negative impact from mega-cap tech businesses. Further, relative to expectations, results have generally been less bad than feared.

A pragmatic way forward would argue three things: disinflationary trends should accelerate as 2023 goes on; we should look through current earnings volatility to better times ahead; and, the Fed has in-built flexibility by remaining data-dependent. An inverse stance might point to the risk of inflation flaring up and/or economic growth deteriorating. We argue simply that it is integral to guard against complacency – the road will be long and winding. Against this background, we see a renewed case for constructive yet balanced approaches to asset allocation. With high levels of cash still on the sidelines, longer-term investors should be looking to lean-in to risk opportunistically.   

Alex Gunz, Fund Manager, Heptagon Capital