View From The Top: Beyond the peak

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: 2023 won’t be a smooth ride for investors, but after the extent of the sell-offs witnessed across all major asset classes in the past year, the odds of the next being as bad for returns look low. We see supportive evidence of a market bottoming process and believe it is better to be too early rather than too late when adopting a more constructive stance. News does not have to be good, just less bad than expected. Beyond the powerful force of mean reversion, we see inflationary pressures becoming relatively less pronounced. At the same time, a recessionary scenario seems increasingly discounted. Earnings estimates have started to fall and markets tend to bottom before the real economy does. We’re not, however, going back to a world of low rates and low inflation any time soon. The new normal may well be an investing environment where there will be no evident consistency of leadership by way of asset class or style. Our counsel is hence to embrace a diverse and pragmatic approach towards asset allocation.   

Asset Allocation:

• Equities: Growth has underperformed value as a style by c20% year-to-date (based on the SGX and SVX proxies for the S&P 500 Index). We believe 2023 may see some reversal of this trend, with government bond yields likely to rise at a slower pace than that witnessed in 2022 and investors potentially being willing to pay more of a premium for growth, in a world where it may become scarcer. The bigger picture debate, however, is whether earnings estimates have further still to fall, which clearly impacts any arguments that see equities as undervalued versus historical norms. We believe forecasts have become relatively more realistic, but a complex set of market dynamics clearly supports a case for exposure to a broad range of styles: growth and value, cyclical and defensive.

• Fixed Income/Credit: The case for government bonds to outperform equities in 2023 is compelling, particularly given the magnitude of the drawdown witnessed over the past year. 2022 looks set to go down as the worst year for total returns in 10-year US Treasuries in at least the last one hundred. Beyond mean reversion and the fact that yields should fall as economic growth softens, in the near-term more elevated coupons do allow an opportunity for investors to earn decent income from this asset class. Our view is far from unequivocal, however, towards credit. Spreads may widen and defaults accelerate in a more challenged macro environment.
• Currencies: We were not surprised to see the biggest monthly decline in the US Dollar Index since 2009 last month. For context, the Dollar had reached a 20-year high against a basket of other global currencies in September. Even if there are structural reasons for long term Dollar strength, in the near-term, the trade appears highly consensual.
• Gold/Commodities: Just as the Dollar has weakened, gold has surged in the past month, concurrent with the assumption (whether rightly or wrongly) that markets are approaching peak rates. We have consistently advocated an allocation towards gold and selected other commodities since we believe they offer portfolio diversification benefits and can serve as an effective hedge.
• 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, but recommend thorough due diligence.
• Cash: Although we see a continued logic in deploying cash tactically and unemotionally, we also recognise the current attractiveness of cash interest-bearing instruments as a bona fide asset class for the first time in decades.

As any keen hiker will know, even after reaching the peak of the mountain it’s not easy making the return journey. There will almost certainly be further challenges, perhaps even some other, smaller hills still to climb on the way back that are not currently visible on the horizon. However, beyond the peak the general direction of travel should be less bad than that which came before. We see this as a compelling analogy which investors might want to use when assessing the year ahead.

We believe it is still relatively contrarian to be optimistic. Latest data show that cash levels held by average fund managers stand at 6.2% with a majority polled by Bank of America Merrill Lynch in their monthly survey favouring this asset class above all others. By contrast, equities are the least favoured. If nothing else, what this information highlights to us is that it is now far too late to be bearish on equities (or fixed income, for that matter). We see substantial evidence supportive of a market bottoming process. To repeat the above: news does not have to be good, just less bad than expected. When we look for support of this thesis, consider not only falling inflation data, but also the powerful force of mean reversion.

Begin with the latter. The up and down moves in both equities and bonds of the magnitude witnessed in 2022 to-date are broadly unprecedented and so unlikely to be repeated. When measured by total returns, this has been the worst year for US Treasuries in at least the last one hundred, and the worst year in the last fifty by a factor of three. At the same time, US equities (the S&P 500 Index) are on track to record one of their ten poorest years in the last one hundred (all data per Bloomberg). The ‘major event’ that some investors may have been looking for as a prompt for a market reset could well have already happened: market sell-offs of the extent witnessed in 2022 are not standard occurrences. The odds, therefore, of 2023 being as bad for returns as 2022 seem low in our view.

To build further on the above beyond, we believe it is better to be too early than too late. One widely held view is that a peak in (US) interest rates is seen as a ‘necessary’ event that is required before the current bear market ends. However, timing precisely such a turning point is not simple. Further, large one-day moves in markets – such as the 5.5% gain recorded for the S&P 500 Index on 10 November – highlight the dangers of missing out on the market’s best days.    

Rather than try to time markets, our emphasis is on the data. Put simply, inflation is becoming relatively less bad. Sure, we’ve had false dawns before, but a new trend – by definition – always has to begin with one data point, and then build from there. October’s print in the US showed a 7.7% headline rate of inflation, down from 8.2% in September. Encouragingly, the Cleveland Fed’s ‘trimmed mean’ metric of inflation also dipped slightly, while the Atlanta Fed’s measure of ‘sticky’ inflation did not increase. Looking forward, we expect a broad-based decline in inflation, albeit one that is not linear. The easing of supply chain constraints is well-documented, but note that oil is at its lowest in almost a year, whereas fertiliser (a key determinant of food prices) is down over 40% from its peak. Correspondingly, US input prices (PPI figures) are now declining year-on-year. Even Germany, where PPI currently stands at ‘only’ 34.5%, has seen its first month-on-month drop since May 2020.

To pre-empt a possible counter-argument, bear in mind that there is no logic for Fed officials to sound less bearish for now. The simple explanation: inflation may be coming down, but it is still high. Expectations also remain elevated. This is hence why Jerome Powell, the Fed Chair, continues to assert that the US economy is “out of balance.” Further, should markets front-run excessively the likelihood of a Fed pivot, then this only complicates further the task of the Central Bank.  Our expectation is for the Fed to remain hawkish, but become relatively less so. After a record pace of US hikes over 2022, it seems logical for the speed and size of interest rate moves to moderate going forward. The Central Banks of Australia, Canada and New Zealand may have set a precedent in this respect, hiking by less than had been anticipated in recent meetings.

Another cause for comfort is that the likelihood of a recession appears to be increasingly discounted. Some countries (e.g. the UK) may already be in contraction. The Fed has gone on the record as saying that there is a 50-50 chance of this event occurring in the US. We should not be surprised. Consider cause and effect. An inversion in the yield curve (whether the 3-month/ 10-year or 2-year/10-year in the US) is the best possible indicator that the restrictive policy implemented by the Fed is working. Logically, in a more challenging economic environment, short term rates should be expected to exceed longer-term ones. Even if there remains a lagged effect whereby it might take 12-18 months for any rate increase to impact the real economy – and so there may be more pain to come – we have sympathy with the Fed view that it makes sense to over-tighten now (rather than the opposite) since higher rates at least provide more future headroom with which to implement any potential reversal of policy.

It is also encouraging to see that Factset consensus estimates now show aggregated forecasts for the S&P 500 falling on a year-on-year basis for the coming three reporting quarters. On this basis, estimates will only begin to rise on an annualised base from the third quarter of 2023. The shift relative to even a month ago – when growth was still being pencilled in – is marked. Back in June, the street was assuming almost double-digit growth. Do not forget, markets tend to bottom long before the real economy does.

Despite all the above, 2023 won’t be a smooth ride for investors. It would be complacent to assume a soft-landing for the economy. The picture in the US is complicated by many current contradictions. a poor housing market but consumers still spending; supply-chain bottlenecks easing, but inventories building – to name but two. Since neither the stock market nor the economy is likely to witness anything close to the V-shaped recovery that occurred in the immediate aftermath of the last (post-COVID) bear market, the investing environment over the coming months will feel all the more exhausting. Based on the past year – one which was characterised by the first hostile invasion in Europe since 1945, the highest inflation in 40 years and the most extreme pace of US Central Bank hiking in the modern era – it might be wise to take all predictions for 2023 with a certain degree of caution. Nonetheless, if anyone can agree on one thing from the last 12 months, then it is just how poorly economists understand inflation – what causes it and why it persists. Against this background, it may be difficult to predict accurately when it ends too.

Put another way, be wary of celebrating too much. We’re clearly not going back to the good old days of low rates and low inflation any time soon. Perhaps the right way to frame forward thinking is to accept that the linear outperformance of long duration assets (and growth in particular as a style) that was enjoyed for essentially the entire period from the end of the Financial Crisis through to the end of the COVID crisis may come to be seen as the exception rather than the rule. The new normal, in our view, will be no consistency of leadership by way of style. Embrace a diverse approach. Volatility should not be seen as a risk; rather an opportunity, particularly for those investors with longer-term time horizons.   

Alex Gunz, Fund Manager, Heptagon Capital