View From The Top: Darkest before the dawn
View from the very top: remove emotion from the equation, be constructive and start to plan proactively for 2023. It might be hard, cognitively, to be optimistic after the drawdowns most asset classes have witnessed year-to-date. However, there is a danger of over-extrapolating the current crisis. Sentiment appears highly polarised towards peak bearishness in our view, while recessionary prospects seem increasingly discounted. US monetary policy will tighten further in the very near-term, but we expect the pace of rate hikes to lessen as the next year progresses. Sure, there are risks attached to this world view. Central Bank policy may result in an error, a financial accident could occur somewhere in the system or the geopolitical environment might deteriorate markedly. Nonetheless, on a 6-12 month view, we believe that things should look relatively less bad. It’s hard to time markets. Instead, it makes sense to be flexible and not too dogmatic. Take a step back and begin to look for opportunities.
- Equities: Given the extent to which equities have declined year-to-date (the MSCI World Index is down over 20% in US Dollar terms), a further move of this magnitude might be harder to sustain. After major multiple compression, markets may only see additional extended downside should earnings disappoint meaningfully. With the exception of the mega-cap consumer technology names, the current results season has been less bad than feared, even if sceptics may be entitled to wonder whether the bar is yet set low enough for 2023. Do not forget that less bad news can have a positive, galvanising effect on sentiment. Many segments of the equities market look attractive after recent drawdowns. We favour allocations to a diverisfied range of styles: growth and value, cyclical and defensive.
- Fixed Income/Credit: Bond markets have undergone a brutal repricing. On one analysis, all the gains generated by global government bonds in the last decade have been erased in 2022 to-date. These bonds now yield an average of 3% relative to 1% at the start of the year, while the yield on US Investment Grade debt has moved from 2% to 5% (all data per Deutsche Bank). After the pain of 2022 – and in the absence of a return to a low inflation world – it is now possible, we believe, to be somewhat more constructive on fixed income. Yields might be lower on a 12-month view, even if it remains important to watch for possible corporate defaults.
- Currencies: Being long the US Dollar is a highly crowded and consensual trade, albeit one that has worked in 2022. While it is hard to envisage meaningful structural weakness in the Dollar near-term, particularly given the Fed’s current focus on fighting inflation, we believe that there is a good possibility of mean reversion over time.
- Gold/Commodities: Exposure in this area offers portfolio diversification benefits and can serve as a portfolio hedge. With a c20% decline in the price of gold from its 2022 peak, now may be an attractive entry point, even if the asset pays no yield.
- Private 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 logic in beginning to deploy cash tactically and unemotionally, we also recognise the current attractiveness of cash as a bona fide asset class for the first time in decades. Short-term yields are the highest since 2008.
To get a sense of how much the world has changed since the start of this year consider the following data: US inflation has risen from 2.5% to 8.2%, resulting in a change in the Fed Funds rate from 0.25% to 3.25% (and rising). A 30-year mortgage in the US now costs 7.2% as opposed to 3.7% in January. Correspondingly, the yield on 10-year Treasury debt has increased from 1.6% to 4.0%, while the median forward 12-month multiple on the S&P 500 Index has fallen from 21.3x to 16.0x (all data courtesy of Bloomberg). Have no doubt, these are big numbers. Such a rate of change in such a short period of time means that investors have felt the pain in all asset classes. The combined market value of the Bloomberg Global Aggregate Bond Index and the MSCI World Index saw $36tr of value erased in the first nine months of 2022.
After this abrupt shift, what conclusions can we draw? Sure, if the 2010s can be characterised as a decade of policy experimentation (primarily by Central Banks), then the 2020s may be thought of as the decade of its consequences. Even if we are almost certainly not going back to the low inflation, low rates environment of the recent past there is, however, a danger in over-extrapolating the current crisis through to infinity. Put another way, on a 6-12 month view, we believe that things will look relatively less bad than they do currently.
If there is one key lesson to take away from the Global Financial Crisis (when your author was already 11 years into his career in finance) then it is to recognise that stressed markets are non-linear markets. There will be no simple journey from panic – the current state, it seems, for many – straight to returning confidence. In between, it’s reasonable to expect phases of both discouragement and reassessment. Very few people, in our experience, are able to successfully time markets. Further, it is hard, cognitively, to be optimistic after such a painful year for most investors, recognising also that we are in a period of severe monetary tightening and deteriorating economic growth. Nonetheless, our counsel is to remove emotion from the equation, be constructive and plan proactively for 2023.
We believe it is fair to recognise that the bear market in all main asset classes seems quite advanced. Certainly when one looks at sentiment, then views are highly polarised – significantly towards the ‘fear’ rather than ‘greed’ camp currently. Jerome Powell’s speech at Jackson Hole in late August may have been the game changer in this respect with it becoming manifest that Central Banks would prioritise muting inflation over supporting financial markets. As a consequence, cash levels among investors are the highest they have been since April 2001, while risks are seen as being at their most elevated since 2008 (per Bank of America Merrill Lynch’s monthly survey). Might we have reached peak bearishness? It seems to us as if ‘everyone’ is now waiting for a big event or major capitulation. As a thought-experiment it might be worth wondering what if such an event were not to occur. Such an outcome is far from a necessary condition for a market bottom.
If you believe the Chief Economist of the IMF, then “the worst is yet to come.” For many, per the International Monetary Fund, 2023 “will feel like a recession.” When such statements are made, it’s important to take a step back: look not only at the data, but also consider the different impact this prediction might have on not only the real economy but also the investing landscape – for they are two different things.
Talk to most investors and a recession in 2023 seems more of a matter of how bad than if. Manufacturing survey (PMI) data around the globe is already signalling that many economies are in contraction. However, even the IMF is still forecasting 2.7% world GDP growth for 2023, admittedly a slowdown relative to the recent past (it predicts 3.2% for 2022, while the economy recorded 6.0% growth in 2021 on a post-COVID rebound), but far from a dire outcome. Even in the US, while Fed policy is having a dramatic impact on financial conditions and markets as well as directly rate-sensitive sectors of the economy (such as housing), a lot of the rest of the economy seems unscathed for now. Consumer spending is still strong and US households are sitting on $1.4tr of savings. Further, US unemployment is very low and there exist 1.4 vacancies for every job application currently (both data points per Alpine Macro).
If there is a day of reckoning for the economy, then it might be some time off. It’s still unclear whether it will be possible to cool inflation via rate rises without provoking a recession. At some stage, higher interest costs will strain the finances of both households and businesses. For now, at least, credit markets seem to be showing few signs of stress, with limited evidence of spreads widening. The more important point, however, is that the likelihood of a recession is increasingly reflected by investors, in our view. When it does happen, markets may already have moved on. Consider that 89% of those polled by Bank of America Merrill Lynch expect profits to worsen in the next 12 months. At the same time, a bigger percentage of NASDAQ Index stocks have now halved in value than occurred after either the bursting of the TMT bubble or the ending of the Great Financial Crisis (per Bloomberg).
It’s also worth remembering the old adage of not to fight the Fed. The US Central Bank’s policy actions (and those of its counterparts around the world) have, arguably, had a bigger impact on asset prices than any other factor year-to-date. However, whatever other criticisms can be levelled against the Fed, it has always said that it would seek to remain data-dependent. By definition, there is no such thing as high and stable inflation. When viewed objectively, the odds of inflation increasing at the same pace in the next 12 months as it has in the prior 12 look exceptionally low – even if we are very unlikely to go back to 2% levels any time soon. Rate hikes can take up to two years to impact the real economy and there is building evidence to suggest that the shelter and wage components of inflation are falling from their highs. Even if another rate increase is considered almost as a given for November, it is interesting to note that while futures (on Bloomberg) are pricing odds of more than 50% that the US Fed Funds rate will exceed 5% by March next year, similar odds are currently being given that the rate will be below 5% by November 2023. Any slightly more positive shift in the direction of travel could be a major balm for financial markets.
Of course, it would be wrong to deny that there are not major sources of uncertainty. Foremost among investors’ minds remains the possibility of a Central Bank policy error. Fed messaging still suggests that underreacting to inflation would be worse than overreacting. Policymakers in particular may still be under-estimating the impact of inflation stickiness and its consequences on market psychology. Another valid concern would be were increasing stresses in the financial system to metastasise into a financial accident. Goldman Sachs notes that current financial conditions are at their most restrictive in a decade. Non-financial corporate debt as a percentage of GDP is higher now than before the Financial Crisis (per the Bank of International Settlements). Finally, don’t forget about grey swans. We are unfortunately living in a highly fraught geopolitical environment. It is still unclear how Putin may seek to force an endgame in Ukraine, while it will also be crucial to monitor the increasingly defiant tone of China.
Against such a background, we believe the most important lesson is to remain flexible and not be too dogmatic. Step back from near-term noise and overreaction to data points. Be patient and pragmatic and start to look for investment opportunities, however uncomfortable it may currently feel. In 12 months’ time the world may be in a very different place.
Alex Gunz, Fund Manager, Heptagon Capital
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