View From The Top: How much more pain?

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: it’s going to be a painful few months ahead for investors. Never before in the modern history of the US has the rate of monetary tightening implemented since the start of the year occurred so fast in such a short period of time. Tighter financial conditions combined with a stronger US Dollar also have severe ramifications for the rest of the world. Forget the possibility of a soft landing. Rather, the odds of a hawkish policy error are only growing. A financial accident somewhere in the system can’t be ruled out. It’s not all bad though. For the much longer-term and more contrarian investor with dry powder, these are potentially exciting times. Sentiment is already very bearish and if inflation is lower in six months’ time, then there are good reasons to believe that markets could be higher. As soon as things become relatively less bad, the pain can begin to lessen. Preserve cash – which now offers a meaningful yield – but look to diversify proactively too.

Asset Allocation:

• Equities: Given the near-term macro backdrop, equity markets globally made new 2022 lows during September. While there has been significant multiple compression since the start of the year (the MSCI World Index’s forward earnings multiple has fallen by five percentage points, to 13.8x, since January), earnings downgrades are only now beginning. Although no two cycles are the same, Bloomberg (also the source of the above data) estimates that a typical peak-to-trough earnings drop would be c30% – and we’re only currently at c10% for the MSCI World. On a regional basis, the US market is, arguably, the least bad place to be currently exposed. Our counsel remains one of embracing a range of styles – value and growth, defensive and cyclical. For the longer-term investors, attractive entry points may be emerging.
• Fixed Income/Credit: The significance of the 2022 bond drawdown means that 2-year US Treasury debt now yields over 4% for the first time since 2008 while yield on the 10-year is at its highest since 2011. The overall US debt curve is now more inverted than it has been at any time since March 2000. On the corporate side, even BB debt in the US now offers a greater yield than that available from the S&P 500 Index. Investors seeking yield, therefore, have a meaningful alternative to owning equities for the first time in recent years. Choose carefully, however, and watch for potential default risks in lower quality areas of the market.
• Currencies: With the US Dollar Index at its highest since 2002 and up significantly against every major currency, there is a clear possibility of some mean reversion. While a strong Dollar may well have negative ramifications for the broader world economy (in the form of de facto tighter financial conditions), it is hard to envisage meaningful structural weakness in the Dollar near-term, particularly given the Fed’s current adherence towards quashing inflation.
• Gold/commodities: Exposure in this area offers portfolio diversification benefits. However, gold tends to prosper best when real rates are falling – and they are currently rising. It also pays no yield. The potential returns available from commodities may also be constrained by a weakening economic backdrop.
• Alternative Assets:  The collateral-backed cashflows available for this asset class can act as both an inflation hedge and a portfolio diversifier. We favour business models with strong balance sheets very selectively within the real estate, infrastructure and logistics spaces.

It’s been a brutal year so far; an annus horribilis for virtually all mainstream asset classes. Almost every major equity market in the world is down at least 20% in 2022, while the Barclays Global Aggregate Bond Index has seen its worst ever drawdown. These (lack of) returns constitute the biggest cross-asset sell-off since 1981 (per Bloomberg). Needless to say, synchronised weakness has wreaked havoc for those positioned with conventional 60:40 equity-bond portfolios.

Investor sentiment is undoubtedly the worst it has been since at least 2008. At the same time, however, we should also be entitled to ask, how much more pain is likely? Listen to Jerome Powell, Chair of the Federal Reserve’s FOMC, and the answer is certainly some: “we’ve got to get inflation behind us. I wish there were a painless way to do that… there isn’t.” Against this background, it is going to be a painful few months ahead for investors before we get better visibility – even if markets may well still be higher on a 6-12 month view. Do not forget, we haven’t seen any major capitulation yet; many investors remain psychologically primed to buy the dips.

The biggest reality to which investors have had to adjust is the rate of change. It is perhaps hard to remember now, but at the start of the year, the Fed Funds Rate (or interest rate) was just 0.25%. Now, it is 3.25%. We’ve had five consecutive rate hikes and three in a row equivalent to 75 basis points each. Never before in the modern history of the US has this level of monetary tightening occurred this quickly. Inevitably there will be consequences, especially since most economists accept that rate rises take up to a year to feed into the real economy.

One obvious conclusion to draw from the above is that a so-called ‘soft landing’ is looking increasingly less likely for the US (and world) economy. However, there is still a state of some denial, since the latest economic projections from the Fed call for US GDP growth to slow to 0.2% in 2022 and then expand by 1.2% in 2023. Sure, the Fed started the year forecasting figures of 1.7% and 2.4% respectively, so this is a big change, but it still doesn’t admit to call for the possibility of recession. Investors have grown up with the mantra ‘don’t fight the Fed.’ A case could be made to reform this to ‘don’t trust the Fed.’ It is hardly confidence inspiring to hear Jerome Powell saying “no one knows where the economy will be a year from now.”

An alternative perspective could be that the above is no more than a simple admission of humility. The paradox for Powell is to remain tough on inflation but not so tough as to trash the economy. If policymakers lean too hard in one direction, it only increases the risks of failing to deliver in the other respect. What we think can be regarded as givens are the following two interlinked observations: inflation has been more persistent than anticipated; and, the likelihood of a possibly hawkish policy error on the part of the Fed is only growing. Such an outcome would only likely prolong both economic and investor pain.

The inversion of the US yield curve (where shorter-dated bonds offer a higher yield than longer ones) is indicative of this concern: more near-term yield compensates for increased uncertainty. Consider that we may already be in a recession. Look from the ground up and the evidence abounds. Fedex’s warning on earnings should serve as a wake-up call. It withdrew its financial guidance in mid-September on a worsening economic outlook, saying “we’re seeing… volume decline in every segment around the world.” When a bellwether such as this comments, it pays to take notice.

The likelihood of a synchronised global recession also seems to be growing. A higher US Dollar is de facto imposing tighter financial conditions on the rest of the world (also do not forget, that quantitative tightening in the US is draining $95bn of liquidity from the US financial system each month). At the same time, Central Banks across the world – from the ECB to the Royal Bank of Australia, via those in Canada, Switzerland, Sweden and the UK – are all also hiking in an effective race to the top. The pain may also be worse outside the US. Europe has an energy crisis with which to contend, while Chinese economic prospects are constrained by its zero-COVID policy. For what it’s worth, 72% of investors (polled by Bank of America Merrill Lynch) expect a weaker global economy in the next 12 months.

Do not forget also that there is a growing risk of a financial accident somewhere in the system, provoked by tighter monetary conditions. Such a ‘grey swan’ could dent sentiment significantly. From where might such an accident come? It could be corporate or even sovereign, given the potentially toxic cocktail of tighter financial conditions, a higher US Dollar and existing debt levels. Non-financial debt is around three times higher than a generation ago (per the BIS) at the same time that the world is increasingly interconnected – much more so than in the 1970s or 1980s. There are precedents of both emerging market and developed world sovereign crises – remember the IMF bailout of the UK in 1976. Geopolitics (an intensification of Russia’s efforts in Ukraine, fault lines emerging in Eurozone politics and so on) only heighten risks.

There are, however, reasons for optimism. Begin with inflation. It may well fall faster than the market anticipates, just as it rose more quickly than expected on the way up. Turning points are always hard to call. By definition, there is no such thing as high and stable inflation. Future moves in its rate will be non-linear. Freight and commodity costs are falling (in Dollar terms – although the currency’s relative strength means that some of these benefits are negated outside the US), while a weakening global cyclical outlook would clearly be conducive to disinflation. If inflation is lower in six months’ time, then there are good reasons to believe that markets could be higher.

Pronounced market gyrations – in both directions – are an inevitable part of the bottoming processes. Sentiment is already very bearish. The meme stock and crypto bubbles have already burst, implying an unwinding of a lot of the equity market’s prior bullishness. Cash balances, at an average of 6.1%, are at their highest held by investors since October 2001, while more are negative on the outlook for corporate profitability than at any other stage in the history of being surveyed (by Bank of America Merrill Lynch). For the longer-term investor, it may pay to be somewhat contrarian. Near-term pain can be offset by the potentially attractive entry points achievable.

Of course, no two cycles are alike and the investment challenges in this one are compounded by the fact that very few in the investment world have either had to live with or trade in a truly inflationary environment previously, at least in the developed world. It is therefore important to be flexible and non-dogmatic; investors need to be patient. For the Fed’s policy to work, it will be a process rather than a singular event. From our perspective, it may be as simple as just understanding and then interpreting the collective view on the direction of Federal Reserve (and broader Central Bank) policy. When seeking direction, what matters is things becoming relatively less bad. That’s when the pain can begin to lessen.

Alex Gunz, Fund Manager, Heptagon Capital