View From The Top: Behind the curve?

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: might Central Banks be about to commit a policy error? Tightening into an economic slowdown almost never makes sense. Potentially higher interest rates will also do little to alleviate what looks to be a supply crunch. An enduring pandemic as well the structural shift towards deglobalisation only complicate matters. The hope remains that policymakers are able to do what it takes both to keep inflation under control and manage future expectations appropriately. Equity investors certainly don’t seem concerned for now, given that markets globally continue to set new records, bolstered by strong corporate results. The party can continue for at least as long as Central Banks remain behind the curve. Enjoy it while it lasts – for it will be hard to time the exact ending – but don’t forget to embrace a range of styles and proactively diversify.

Asset Allocation:

• Equities: Global markets are close to all-time highs, helped by a strong earnings season (to-date, over 80% of S&P 500 companies have beaten consensus expectations versus a long-term average of 64%, per Bloomberg). Inevitably the bar is now set higher for 2022. Even if many stocks may arguably be in bubble territory – at least on conventional valuation metrics – some clearly offer a greater margin of safety than others. There’s an argument for paying up for growth in a world where it is increasingly scarce, but also strongly balancing this with value. China looks interesting for the longer-term investor.
• Fixed Income/ Credit: Contrarians would note that after the worst year for government bonds since 2005 and with investor allocations to this asset class at 20-year lows (per Bloomberg and Bank of America Merrill Lynch respectively), some segments of the fixed income market are now looking attractive. Low yields and inflation risks are generally an unappealing combination, but yields across the curve are being repriced on the prospect of interest rates rising earlier than expected. Our allocations remain limited for now. Also watch for growing default risks in the high yield space.
• Currencies: It’s hard to argue against further strength in the US Dollar, notwithstanding mean reversion. Even if the Federal Reserve may be behind the curve, rates are likely to rise earlier in the US (and perhaps the UK) than other developed world geographies, which would support the currency. Additionally, a switch to risk-off generally benefits the Dollar. Longer-term, however, don’t forget about the magnitude of America’s twin fiscal and trade debt burdens.
• Alternative Assets: We favour increasing allocations to this space since these assets bring clear diversification benefits to portfolios. We are also attracted to the collateral-backed cashflows that these assets generate. We expect infrastructure assets to benefit from ongoing fiscal stimulus initiatives. Additionally, we advocate exposure to business models with strong balance sheets such as seniors’ housing or logistics REITS.
• Gold: We see a continued place for gold in investor’s portfolios. Uncertainty is generally good for this asset – own gold if you think the Fed is likely to make a policy error. Also consider the case for listed gold miners, which offer an inexpensive (particularly versus US equities) and indirect way of gaining exposure to this asset class.

The COVID-19 pandemic has clearly not gone away. However, the compulsive checking of new cases has been replaced by a new obsession – the analysis of inflation numbers. Have no doubt, the consensus view on the global economy has fallen apart spectacularly over the last six months. Growth expectations have declined and inflation forecasts have risen. The deteriorating picture has not been helped by the refusal of the pandemic to disappear. Take a look at equity markets globally – which are sitting at close to all-time nominal highs – and it’s not unreasonable to wonder whether investors care.

How best then to square this disconnect? We provide three simple observations and one conclusion: nobody really knows about inflation; there is the hope that Central Banks will provide a continued backstop; and, among mainstream asset classes, equities remain (by default) the place to be, bolstered by another strong set of earnings. Against this background, enjoy the party while you can, but also proactively diversify. Bubbles (we use this word with some reluctance, but think about Tesla as a current poster-child; worth over $1tn and trading on a multiple of over 20 times sales), by definition, will continue to expand until they pop – and then it will be painful. Corrections, of course, are sadly almost impossible to time.

Back to inflation and based on the number of column inches written on this topic, it’s hard to dispute the current infatuation. Perhaps it’s the uncertainty or cognitive dissonance from having lived in a world absent of inflation for some time. For a long time we sat in the deflation camp, but to borrow from Keynes, when the facts change, so must we. Deglobalisation and saving the planet are inherently inflationary, whether you like it or not. The former implies more stockpiling, less mobility, a greater scarcity of labour and higher import prices. Green agendas also unfortunately come with high (switching) costs attached. There is no free lunch.

The pandemic only exacerbates matters as constraints limit escape velocity. Consider that the cost of charting a 40-foot container along a major route has increased by a factor of five in the last two years. As a result, the number of container ships anchored at the ports of Los Angeles and Long Beach are at record levels. The former is operating 24 hours a day currently (all data per The Economist). Listen to Prologis, the largest owner of industrial real estate globally: warehouse space is “sold out” with demand at an all-time high. Then there is the complicating factor of the labour market, particularly in the US. The pandemic has revolutionised worker expectations and the basic terms of employment. America has seen the largest drop in its participation rate since the Second World War. There are currently 10.4m job openings (per the Labour Department). What seems to be going on is a larger dispersal away from offices, cities and commutes in pursuit of ‘better’, increasingly remote work. Regardless, it’s not good for inflationary dynamics.

We shouldn’t be surprised then that the expression “supply chain” was mentioned over 3,000 times in earnings calls by S&P 500 companies in the first two weeks of the current earnings season (per Bloomberg). Almost every company (and its analysts/ investors) seems concerned and expects issues to persist into 2022, whether these relate to transportation, materials or labour. Take the fact that the National Federation of Independent Businesses in the US reports that 51% of organisations cannot fill jobs – a third consecutive monthly record – while an unprecedented 42% have been forced to raise compensation. If employees have any sense, they are going to ask for higher wages – and given the current levels of vacancies, it will be hard for business owners to refuse. Current American consumer price inflation of 5.4% is already wiping out hourly wage growth of 4.6%.  

Against this background, the IMF has recently warned that the global economy is “losing momentum” with inflation risks “skewed to the upside” and those for growth “tilted to the downside.” Investors seem to concur, with the percentage forecasting below-trend growth and above-trend inflation at its highest since 2018, per Bank of America Merrill Lynch’s latest monthly survey. One-year inflation expectations in the US stand at 4.8% (per the University of Michigan) while five-year break-evens topped 3.0% for the first-time ever during October. Ten-year breakevens are at the highest since 2004.

This is an unappealing cocktail of circumstances if you’re a Central Banker. Tight labour markets and rising wages sit at odds with Fed policy. The strong conviction enunciated by Jerome Powell (and others), that inflationary pressures were only transitory is now being tempered. The Chair of the Federal Reserve noted on 22 October that “supply constraints and elevated inflation are likely to last longer than previously expected and well into next year, and the same is true for pressure on wages.” Traditional Central Bank tools can do little to solve a supply crunch.

It’s hard then not to worry about the possibility of policy error. Tightening into an economic slowdown almost never makes sense. Yet this is just what economists seem to be predicting. Bloomberg’s world interest rate probability tool (‘WIRP’) assumes two hikes in the US over the next 12 months, a view corroborated by Reuters’ latest survey of economists showing almost 60% of those polled forecasting an interest rate rise before 2023. If there is a hike, what you might simply get is tighter liquidity (and higher bond yields), while inflation expectations will remain elevated at least until supply chain issues resolve themselves.

However, the Fed appears damned either way: if it tightens too early then it risks curtailing a still-nascent recovery, but if it tightens too late, then inflation may have got out of control. Of course if you believe the Federal Reserve, then core inflation will be 2.0% by the end of 2022. To suggest otherwise might be an admission of weakness. For context, the last reported figure was 4.3%. Our sense is that Central Banks generally will end up moving gradually towards tighter monetary policy. The alternative would be to risk losing control. The IMF calls for “vigilance.” We would also add into the mix that the reappointment of Jerome Powell is by no means a foregone conclusion (an announcement will be made by February) and adds an additional source of uncertainty.    

So why equities? The answer, simply, is that there is no better liquid alternative. What investors are buying is not the world economy but corporate earnings. Recent beats to consensus expectations seem to have trumped inflation concerns. Even if you’re worried about higher wages potentially eating into peak corporate margins, bulls can square the circle by arguing that businesses with pricing power should still be able to drive earnings growth. Strong balance sheets with high cash levels (a fact also shared by many consumers) are also supportive. Nonetheless, equity markets that appear priced for perfection at a time of slowing growth and likely less accommodative Central Banks offer up a poor combination for future (high) returns.

With asset allocators more underweight fixed income than at any other time in the last 20 years, a contrarian might argue that this is a potentially attractive time to be considering their relative merits. At least for now, or for as long as Central Banks remain behind the curve, we see the case for enduring equity outperformance. However, all good things do come to an end and our enduring counsel remains that of embracing both a range of styles and proactive diversification.

Alex Gunz, Fund Manager, Heptagon Capital