View From The Top: Wake up and smell the monetary coffee

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: the Fed is set to tighten until something breaks; either the economy or markets, or even both. Supply side shocks (first pandemic, now war) inevitably push inflation up and demand down. Central Banks are then faced with a choice of killing inflation or growth. Soft landings almost never happen. In the absence of one, an economic recession would be increasingly probable. With the worst sell-off in bonds in recent history witnessed year-to-date, fixed income investors have recognised this new world reality more easily than their equity counterparts. This explains why stock markets globally are beginning now to crack. The future direction of travel will not be linear – expect some countertrend rallies – but it’s important to position appropriately. Investing under inflationary conditions is hard. Continue to diversify and embrace collateral-backed cashflows.

Asset Allocation:

• Equities: The MSCI World Index suffered its worst month in April since the start of the pandemic in 2020. While this index is down c15% from its recent high, others have fallen markedly more, while c40% of the NASDAQ’s constituents have seen greater than 50% drops from their 52-week peaks (per Bloomberg). Even with earnings estimates still rising for now, investors are positioning themselves more defensively. Value has massively outperformed growth as a style so far in 2022 and will likely continue to do so in the near-term. However, with further rallies (such as that witnessed in March) likely amidst the general downtrend, we think there is logic in embracing a range of styles, both growth and value.

• Fixed Income/Credit: The drawdown in conventional fixed income has been even more pronounced than that in equities. As the stock of negative yielding debt has shrunk significantly, some form of normality is finally returning to debt markets. With real yields in the US close to zero, the case for fixed income is becoming more compelling. We see the risk-reward profile for the broad asset class as better balanced than it has been for some time. Credit spreads remain narrow, although a weaker economic backdrop may challenge this assumption. Our fixed income allocations continue to be limited for now.
• Gold/Commodities: Our positive stance on this asset class continues to grow, particularly given the current geopolitical backdrop of supply constraints combined with growing demand. Accelerated energy transition strategies by western governments will also be supportive to this dynamic. Gold and commodity assets also tend to outperform in more inflationary environments and could further be considered to represent a store of value in times of greater stress.
• Alternative Assets: We reiterate our stance of increased allocations towards this space. Take advantage of still-low real interest rates to gain exposure to hard assets. Collateral-backed cashflows are attractive since they can act as an additional inflation hedge. Favour business models with strong balance sheets. Look to real estate, infrastructure and logistics.
• Currencies: Recent events have reinforced the strength of the US Dollar as well as its safe haven currency positioning. Both the Euro and Yen are at corresponding relative lows. Accelerated tightening may lend further support to the Dollar in the near-term.

At first there was denial; now there is realisation and recognition. If the maxim is true that “sooner or later everyone has to answer to the bond market”, then look at recent moves in global equities. Investors in all asset classes are now having to accept an environment of higher interest rates, slower growth and a withdrawal of liquidity from the financial system. It’s an unappetising combination.  Should this macro set-up not be concerning enough, then it’s important also to contemplate the probable next phase, still to come: demand destruction and potential recession.

Have no doubt, there has been a structural shift in the world order. Think of it as a move away from globalisation towards deglobalisation; a transition from three decades of broad post-Cold War abundance, low interest rates and low inflation to a new era characterised by scarcity, supply shocks and bottlenecks, not to mention heightened geopolitical tensions. None of these issues can be resolved overnight and most will likely persist for many years. The consequence is an upward shift in inflationary pressures; a regime change towards structurally lower growth and higher inflation.

The data bear out this contention. US CPI inflation stands at 8.5%, its highest since 1982 and an acceleration relative to levels reported a month prior (7.9%). It’s hard to consider this at all transitory, when global food prices are rising at their fastest pace ever. Wheat and corn are up over 40% and 30%, respectively, year-to-date (per Reuters). Just as correlations in a financial crash go to one, so the same seems to be occurring currently across the food chain supply. Even if CPI is higher in the US than any other G7 country, inflation is a global phenomenon. In the Eurozone, it stands at 7.5%. Everywhere, breakevens (i.e. implied levels of future inflation) are making new highs. Further, it should be no surprise that with prices rising faster than anyone the age of your author (46) or under can recall explains why economic confidence is almost its lowest in 25 years, worse only during the Financial Crisis (per Gallup, data for the US). Falling real wages and rising living costs are clearly negative for sentiment.

To the credit of Central Banks, they’ve finally started to wake up to the seriousness of the problem. If you want a gauge of their intent, consider that at the start of April, investors saw a less than 5% chance of US interest rates being above 3.0% at the end of 2022. Now, the probability is more than 75% (per Bloomberg). For context, the current Fed Funds Rate is 0.25%. At the start of the year it was zero. Officials across the world seem desperate to avoid a repeat of the 1970s.

Bond market investors perhaps smelt the coffee (of tighter monetary conditions) earlier than their equity counterparts. We’re witnessing the worst sell-off in bonds in recent history. The US Treasury Index has seen its most significant drawdown since 1974. Corporate bonds endured their worst quarter through to the end of March since the Great Financial Crisis. Whereas the total stock of negative yielding debt stood at $14tr globally at the end of 2021, the figure has now shrunk to $2.7tr. At the same time, the yield on the Bloomberg (also the provider of all these statistics) US Corporate Bond Index is now 3.7%, over three times higher than at the end of 2020.

The disconnect is stark between just how terrible bond market performance has been when compared to how the equity market has held up relatively well. The latter now looks as if it is beginning to crack. When pressed, equity investors have probably ‘known’ that something was wrong, but have carried on broadly regardless. A recent survey (by Bank of America Merrill Lynch) shows that 71% are expecting weaker economic growth over the next 12 months, the most pessimistic percentage on record (dating back to the series start in 1995), worse than in 2008.

A slowdown in economic growth seems inevitable. Both the IMF and the World Bank have cut their global economic projections for 2022, by 80bp and 90bp respectively. If their assumptions are correct, then the world economy will still expand by at least 3.0% this year and by a similar level in 2023. However, what’s not priced in is the possibility of recession. High inflation, tight labour markets and an uncertain (inflation) outlook would suggest the risk of a 1970s wage-price spiral. Walmart is, for example, paying new truckers annual salaries of up to $110,000 versus a previous ceiling of $87,000 (per Bloomberg). Once in train, this vicious circle is hard to reverse. History would suggest that soft landings almost never happen. Indeed, with hawks seemingly in the driving seat at the Federal Reserve and beyond, a hard landing may be more likely.

Supply-side shocks (first pandemic, now war) push inflation up and demand down. Central Banks are therefore forced to choose between embracing recession or inflation. The Fed seems set on the former path. We are of the view that it will be hard to get inflation down without slowing growth to below trend and to avoid doing this without provoking a recession. Tightening monetary conditions stops inflation by de facto reducing liquidity and so lowering investment and effectively engineering the destruction of demand. The expectation is that rates will keep rising at least until something breaks, either the economy or financial markets.

A more optimistic view would suggest that the more the Fed hikes now, the greater would be the headroom to cut rates at a later stage. Further, the next recession is unlikely to be anywhere as severe as the Great Financial Crisis since housing and consumer balance sheet fundamentals are robust. 20% of Americans account for c50% of consumer spending – and their net worth is at record levels (per KKR). Corporate credit spreads also remain tight.

We should also not forget that everyone seems now to have become an inflationista. When consensus is so strongly positioned, it always makes sense to think about contrarian ideas. An argument can be made that this may be as bad as it gets for inflation. Forward-looking measures may be peaking, even if bad (supply chain-induced) news may persist for the next few months. It would not take much of an economic slowdown for long yields and inflation expectations to plateau. It may also perhaps be too simplistic to assume that there is a binary choice between killing inflation but then suffering a recession, or avoiding a recession and managing to live with inflation. Things are rarely linear.

If we accept the above logic, then it seems only reasonable that there will be countertrend rallies (such as in March) as Central Banks tighten into an economic slowdown. Our opinion is that there is little point in trying to be too heroic. It’s better to try and position pragmatically. Investing under inflationary conditions is hard. Forget 60:40. Even if you believe that commodities are the place to hide, then remember that they’ve already risen by an average of 50% since US inflation hit 2% last year (per Bloomberg). Equities may well have outperformed relative to conventional fixed income, partly given the TINA (‘there is no alternative’) mindset adopted by many when contemplating liquid assets. However, after large year-to-date losses, the risk-reward on fixed income looks considerably more compelling. Meanwhile cash now offers some yield for the first time in a long while. From our perspective, keep diversifying. Beyond the more conventional, look to own collateral-backed cashflows and assets which offer inflation protection. 

Alex Gunz, Fund Manager, Heptagon Capital