Between Scylla and Charybdis....
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: Both policymakers and investors face currently unappealing dilemmas. For the former, it is crucial to manage policy such that neither inflation becomes rampant nor that efforts to manage it choke off a nascent recovery. It’s a delicate balancing act, complicated by transitory elements and the fact that joblessness might be the bigger concern than prices. Recent history suggests don’t fight the Fed. At the least, if the reflation trade is on hold for now, then this calls for a potential repositioning in allocation strategies. However, with many asset prices elevated, their high starting points imply future lower returns. Rather than accepting this outcome (or risk reducing returns further through either more defensive or specifically more aggressive approaches), our game plan remains centred on proactive diversification across the spectrum, seeking to find niches and specialists.
- Equities: Indices across the globe made new nominal peaks in June and may move still higher. The clear commitment of the Federal Reserve to manage inflation is inherently more positive for equities relative to fixed income, especially longer duration business models. We favour continued exposure to a variety of styles (growth and value, quality and more cyclical) even if the former categories may be more poised for near-term outperformance. For all equities, the upcoming earnings season with favourable year-on-year comparisons could prove supportive to valuations.
- Fixed Income/ Credit: The shape of the yield curve has changed markedly in the past month. It has flattened, with 30-year US Treasury yields below 2% for the first time since February (and the 10-year at 1.47% versus 1.74% a quarter prior). Correspondingly, investment opportunities within the government bond space look less compelling than previously. Our counsel for limited allocations to the space is also reinforced by the fact that investors have increased attention on riskier segments of the market (with higher yielding prospects), leading to a narrowing in spreads.
- FX: The significant recent move in the US Dollar follows a period of relative weakness. The trend towards a stronger Dollar (positive for the Euro, less so for many EM currencies) may prevail for the near-term, even if concerns over America’s twin deficits (fiscal and trade) may argue for structural pressure on the Dollar over time.
- Gold: Dollar strength has been accompanied by a significant recent retreat in the gold price (down over 7% in June). We see a continued case for gold in investors’ portfolios, with the recent weakness representing an opportunity. It is both a very good portfolio diversifier and also a low-cost portfolio hedge (particularly in the event of policy error).
- Alternative Assets: Similar in some ways to gold, these assets bring clear diversification benefits to investor’
’s portfolios. We are also attracted to their income-generating potential and the protection they would offer in the event of higher inflation. We expect infrastructure assets to benefit from a ongoing fiscal stimulus initiatives. Elsewhere, we see selected opportunities for business models with strong balance sheets such as seniors’ housing or logistics REITS.
Might Jerome Powell, the Chair of the Federal Reserve be a modern-day Odysseus? Homer’s famous hero had, among other things, to navigate successfully through the Strait of Messina, warding off equally unappealing sea monsters (Syclla and Charybdis) on both sides. It is easy to see the relevance of this metaphor when considering how to chart an appropriate course for the economy (and hence for asset allocators), with the threat of stagnant growth at one poll and potentially rampant inflation at the other. Further, being in the Fed’s position is unenviable. Not only do other Central Banks tend to follow the lead of the Federal Reserve, but for many investors, the winning strategy for at least the last two decades has been not to bet against the Fed. Investors face an additional complication: with many asset prices currently elevated, how then to position most appropriately, given the implied high likelihood of lower future returns?
Without doubt, the biggest event of the past month was the Federal Reserve’s press conference of 16 June. As a reminder, 7 of the 18 members of the Federal Open Market Committee now expect interest rates to increase in 2022, and 13 committee members a year later. A month prior, these figures had been 4 and 7, respectively. Investors took this new information as an explicit change in tone, or a hawkish surprise, with asset prices acting accordingly. However, taking a step back, it is remarkable that investors should pay so much attention to the forecasters’ estimates for interest rates in 2023, given their historically poor track record of accuracy. Also, remember that the ‘dot plots’ are just a selection of different people’s opinions about the likely pace of policy, and not a unified statement.
What the Fed’s seemingly revised stance implies is the end of the reflation trade, for now. Given the recent economic and investment backdrop, such a strategy may have sown the seeds of its own destruction. If (too much) growth and reflation were to have persisted, then the Fed would be needed to – and did indeed – respond. Certainly, an optimistic, or constructive view is that the Fed’s positioning should represent a return to normalisation, both in terms of the economy and hence policy too. Think of the direction of travel as being a very gradual weaning off stimulus, even if the risks of a tantrum remain.
At the least, the Federal Reserve is probably ‘hoping’ that inflation will go away. Not only is it a fair concern that persistent above-target inflation may seep into public perceptions and move expectations higher, but were interest rate policy really to tighten, then there would be the clear risk of such an approach precipitating a stock market dislocation. The good news is that not only do 72% of investors currently see inflation as transitory (per the latest Bank of America Merrill Lynch Fund Manager survey), but also that the reaction of markets to the Fed’s apparent policy shift was encouraging, at least from the perspective of equity indices marking new highs. Just as policymakers got last year’s ‘depression scare’ at the start of the pandemic’s onset right, so the hope follows that the current ‘inflation scare’ might be similarly managed. Don’t bet against the Fed.
How much, then, to read into recent data points? Sure, there have been two very strong months of core inflation in the United States, of 3.0% and 3.8% respectively, implying the fastest annualised pace since 1982. Bloomberg calculates that median inflation across the G20 of 3.8% in May (no figure for June is yet available) constitutes the highest in 13 years. However, some data are also supportive to the peaking of inflation. The main constitutents of May and June’s significant readings in the US comprised vehicle rentals, used cars & trucks, airfares, new vehicles and household furnishing. The mundane reality is that most people only buy a new car or redecorate once. When asked “is this a good time to buy a house?”, consumers polled by the University of Michigan gave a more negative response than at any other time in the past 35 years. Against this background, it is notable that three-year inflation expectations in the US have fallen by 50 basis points (to 3.1%) over the past month.
Maybe the more important data points to consider are those relating to joblessness. Two strong consecutive monthly inflation readings have been accompanied by two weak months of non-farm payroll data in the US. The Bureau of Labour Statistics says that America still has 7.6m jobs to recover from the pandemic, while the proportion of the working age population in employment is the lowest since 1983. This may perhaps explain why there are currently over 9m job openings.
At heart, for our modern-day Odysseus, a conundrum exists: there is higher inflation but lots of joblessness. The Fed, therefore, might be right to worry more about growth. There is certainly a clear chance that growth could disappoint, especially given what’s already discounted. Expectations are perhaps as high as they can reasonably get, especially given the coming likely deceleration in the pace of monetary and fiscal support. Weekly stimulus cheques were halted in 18 US states in June, with a further 6 to come in July. The remainder are set to end in September. Powell’s message subsequent to the Fed’s press conference has been very clear: on 22 June, he stated, “we’re not close to hiking” given that the economy is “digging out of a deep hole” with “a long way to go.” It almost seems now as if the Fed is reverting to its previous message of lower for longer, which might help explain too the current equity market euphoria.
The challenge of navigating between the rock and a hard place should be abundantly evident. If the Fed tightens too soon, it may impact asset prices and undermine current momentum. However, were the Fed to let inflation run, then there could be the risk of inflating a possible bubble, with marked after-effects, perhaps along the lines of the magnitude seen in 2000-1 or 2007-8. An additional concern is that simply by talking about the possibility of tightening, a policy error might be (or have been) committed, should nascent growth be stifled. Sure, under this scenario, inflation may temporarily abate. However, were it to create false optimism that current inflation was indeed transitory, and then were inflation to accelerate for real, then, the real problems might begin (not to mention the impact on the Central Bank’s credibility).
It’s not easy being a Central Banker; you are constrained. On the one hand, if they are doing their job properly, then they should not care what politicians, let alone investors think. At the same time, it is inescapable that Central Bank policy has become de facto politicised. The prevailing government view across the G7 (and further) is that no amount of spending is too much if it is to address the two perceived ills facing modern society: global warming and inequality. The so-called race to net zero emissions and levelling up initiatives are inherently inflationary. There’s also the small issue of $281tr of global debt (per the International Institute of Finance). At some stage, there will be a reckoning. In the absence of sustained growth or increased taxation (which seems off the cards for now), inflating it away may be the ultimate solution.
At the same time, it’s not easy being an investor either. We wonder for how long can the current rally endure, particularly given that exuberance can become contagious. A balanced response would suggest that there has to be a limit to bullishness simply because high asset prices will constrain long-term returns. Investors face their own Odysessian moment. The choices of accepting lower future returns, positioning defensively (with the possibility of even lower returns), going to cash (ditto) or adding risk at elevated levels (in the hope of being able to boost returns) are all unappealing. Fortuitously, however, there is a solution at hand. Our counsel for some time is to continue diversifying. Even if there is an inevitable illiquidity premium attached to some strategies, the way forward, we believe is to specialise in more niches.
Alex Gunz, Fund Manager, Heptagon Capital
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