View From The Top: Back to reality
View from the very top: We need more humility. 2023 is a year that has confounded most investors to-date. Equities may be up, but only a minority of active managers are outperforming. At the same time government bonds have been on a round trip, with the yield on US Treasuries now higher than a year ago. Both the resilience of the US economy and the boom in AI have caught many by surprise. Accompanying these dynamics is a growing realisation that there will be no return to the cheap money era of the 2010s any time soon. Put another way, even if much of the tough work on quashing inflation has now been done, investors may well have to live with a higher rate environment for longer than had been previously assumed. With the economy yet to feel the full pinch of tighter monetary policy, charting a path forward may be challenging. The timing of any Central Bank policy pivot also looks uncertain. We counsel caution. Keep things simple. Deploy cash judiciously and seek to find a healthy balance between equities and fixed income. The former are, arguably, overbought and the latter oversold.
- Equities: We were not surprised to see equities retreat from their highs over August. For context, the first seven months of 2023 saw the best year-to-date performance for the MSCI World since 2009. Corrections are necessary. Our sense is that equities may remain somewhat range-bound in the near-term, particularly as the buzz around AI becomes overshadowed by a debate around whether Central Banks need to keep rates higher for longer. Such a scenario, particularly if it were to induce recession, would clearly have a negative impact on earnings. Earnings growth for the S&P 500 Index is currently at its weakest since Q3 2020 (per FactSet), which will constrain valuation upside. We believe active management will only matter more and favour strategies across a range of styles: growth and value, quality and cyclical.
- Fixed Income/Credit: The abrupt move upwards in bond yields has seen 10-year US Treasury debt reach levels not seen since 2007. As a consequence, if such levels are sustained, investors in fixed income may have to endure a third consecutive year of losses. Inflation expectations still do not seem firmly anchored. From our perspective, the current risk-reward profile looks highly favourable for high-quality (government and corporate) credit. We see merits in adding duration and taking advantage of the current sell-off. Fixed income as a broad category looks oversold.
- Currencies: The rise in US Treasury yields has been accompanied by a stronger Dollar, currently at a two-month high. This strength may endure in the near-term, particularly given the DXY Index (which measures the currency against six others) had hit a 15-month low in July. This has clear negative implications for EM currencies.
- Gold: We continue to see an important role for gold in portfolios. While the asset offers no yield, it can act as a hedge against geopolitical uncertainties as well as buffer against market volatility, particularly given its largely uncorrelated nature with (US) equities. We also note active buying of gold on the part of Central Banks currently.
- Alternative Assets: We continue to see a case for owning assets with collateral-based cashflows, as a form of diversification within portfolios. Our stance has, however, always favoured being selective across this broad and diverse area. Commercial real estate remains a source of near-term risk in our view.
A summer of record-breaking temperatures is now over for most. In its place come not only shorter days and cooler evenings, but a return to reality. The bull market in equities and all things AI caught many by surprise. Similarly, the resilient robustness of the US economy has confounded consensus. Both may endure, but our sense is that they will also be accompanied by a growing realisation – a return to reality, if you will – that an era of low rates is not something investors should expect any time soon. This has clear investment implications.
In a complicated world, it’s often helpful to have some simple rules, particularly since no market participant will ever be in a position to know everything. Humility should be an important part of any investor’s toolkit. Against this background, it seems fair to contend that asset prices should rise when interest rates are falling and vice versa. However, it’s never quite as simple as that. Even if they are imperfect, markets tend to be forward looking. Bubbles can also last for a long time. As John Maynard Keynes famously noted many years ago, “markets can stay irrational longer than you can stay solvent.”
Mixed messages have been a large part of 2023’s investment story. Sure, equities have rallied. However, dig below the headlines and a quite different story emerges. Recent data show that while the seven biggest companies within the S&P 500 Index have risen by an average of 50%+ year-to-date, the remaining 493 constituents have eked out a markedly less impressive sub-5% average gain. This perhaps explains why fewer than a third of active managers in the US are outperforming their benchmark in the US, the worst outcome in well over a decade (data per Goldman Sachs).
A similarly confusing picture may emerge from looking at bond markets. Yields (on 10-year US Treasury debt – as a proxy) looked as if they had peaked in October last year, at around the same time that equity markets appeared to have troughed. However, since then they have gone on something of a round trip: from 4.2% in October 2022 to 3.3% in March 2023, and now back close to 4.2% again. At the same time, a yield curve that was deeply inverted (i.e., with longer-term bonds yielding less than shorter-term debt instruments) at the start of the year seems in the early stages of reversing its inversion.
So, what’s going on? If keeping things simple matters, then investors could do worse than remembering the maxim don’t fight the Fed. A more nuanced way of putting this would simply be to listen to what Jerome Powell is saying. We believe that the clearest message from recent commentaries is that higher rates are here to stay, at least for now. Even if a soft-landing currently appears to be the most likely scenario for the US economy, those hoping for an imminent reversal of current Fed policy may be disappointed.
Even with higher interest rates, the (US) consumer is continuing to spend. Last month’s retail sales growth was almost double the level that had been forecast. This has been helped by a continued rise in wages, up 4.4% per the last report. Unemployment, at 3.8%, stands close to record lows. Businesses see this as a propitious time to be investing. No surprise then that consensus estimates currently assume well over 3% US GDP growth for the third quarter, an acceleration relative to the prior two (2.0% and 2.2% respectively). Such data are highly supportive for any ‘soft’ or ‘no’ landing thesis but are less helpful for policymakers. Similarly, while stubborn inflation in a 3-4% range may make for fewer headlines than the surging levels of last year, such rates are still clearly frustrating.
Sure, much of the tough work on quashing inflation has been done but there would be little logic in abandoning a hawkish tilt too early. A hard-learned lesson from previous eras is not to declare victory too soon. Such a view was evident
in Powell’s Jackson Hole speech where he stated that inflation “remains too high” and that the Fed would “be prepared to raise rates further if appropriate.” Christine Lagarde at the ECB echoed a similar message. However, there remains a clear danger of doing too much. Certainly, the historic approach pursued by Central Banks has been to continue tightening until something does break.
A more subtle interpretation of the above dynamics would be to recognise that even if interest rates do not necessarily need to go any higher, they may remain at current levels for longer than is currently discounted. To believe that interest rates of, say, 4.0-5.0% endure for some time is far from an outlandish assumption. In the pre-GFC era, this was the norm. Structural factors (the costs of converting to alternative energy and simultaneously reshoring supply chains in the face of geopolitical uncertainties) may also argue for higher medium-term inflation and correspondingly more elevated rates.
If we are then potentially in a new-normal environment, then there will be no return to the cheap money era of the 2010s. A more expensive cost of borrowing could be here to stay. This perhaps provides an explanation of why the year-to-date number of large companies (300+) declaring bankruptcy in the US is at its highest since 2010, per S&P Global. Further, the latest Senior Loan Officer Survey shows that conditions now are tighter than they were during the Financial Crisis. No surprise then that new loan demand is down.
It’s also worth wondering how the US consumer may fare once current cash reserves accumulated during the COVID era have been burned through. This may be done by the end of Q1 next year at the latest, per Morgan Stanley. As the credit cycle turns, things will get more difficult. Credit card delinquency rates are already approaching 2008 levels. The economy has yet to feel the full pinch of tighter monetary policy. Even if incoming economic data continues to remain generally strong, it would be naïve to assume that policymakers have been able to abolish the business cycle.
China constitutes an additional complication. The headlines are almost unambiguously negative, speaking to a crisis in confidence on the part of both consumers and businesses. Visibility is low, but it seems evident that the disconnect in economic growth prospects between the US and China is only widening. While this development may be welcome news for hawkish US politicians, it’s important to remember that a weaker Chinese economy will impact global growth (and profit) assumptions. Notwithstanding current resilience, the US economy does not operate in a vacuum. This dynamic may only become more evident as the benefits of the post-COVID fiscal stimulus wear off in the US.
It is, of course, possible to chart a path forward. Some combination of weaker inflation (and here, the de facto exporting of Chinese deflation could be considered helpful) and slower GDP growth would clearly give the Federal Reserve better grounds to contemplate a potential policy shift. Timing this is much harder. Further, to assume that rates fall markedly may just be too optimistic. Other factors to consider in the mix are the extreme polarisations in US politics (the Presidential Election is just over a year away) and a multitude of ongoing geopolitical stress points. With no easy options, we believe balance will be critical from an asset allocation perspective. Thoughtful risk management lies at the heart of long-term investing success.
Alex Gunz, Fund Manager, Heptagon Capital
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