View From The Top: If Jerome doesn’t know…

View from the very top: Not all is well. Both equities and bonds have moved downwards in lockstep over the past quarter. Policymakers, economists, forecasters and investors seem confounded by a complex macro picture where resilience has endured even in the face of mounting headwinds. We believe that a reckoning is needed. A world of enduring inflation and correspondingly higher interest rates for longer has still not been fully discounted. This is especially true when looking at bottom-up earnings estimates for 2024. Recessions almost always begin in the corporate sector, where we believe leverage is a clear and growing concern. A soft-landing scenario seems just too optimistic. We may even want to consider an alternative outcome: what about a perfect storm, generated by a synchronised global economic slowdown? For investors, this suggests caution when thinking about asset allocation. Our counsel advocates ongoing diversification, especially into uncorrelated assets. Holding cash at current rates and then deploying tactically also makes sense.

Asset Allocation:

• Equities: The MSCI World Index has just recorded its worst quarter of performance in a year. We think it is fair to wonder how much more pain from rising bond yields (in the form of higher discount rates) equities can tolerate, especially in the context of a highly distorted market. The current concentration of market leadership in a very small number of stocks is the highest witnessed since 2001. Bottom-up earnings forecasts, which assume over 10% growth next year also look too optimistic, particularly given economic headwinds (all data per Bloomberg). Now is logically a time for truly active management and conscious diversification across styles: growth and value, quality and cyclical.
• Fixed Income/Credit: The yield of 10-year US Treasury debt has moved up by over 100 basis points in the last five months and stands at its highest since 2007. Real (inflation-adjusted) yields are at their highest since 2009. If, as seems likely, yields remain at elevated levels through the remainder of this year, then 2023 would mark a historic first. It is unprecedented in modern times for government bonds to have recorded three consecutive years of losses. With US equities having outperformed bonds markedly over this period, there is a clear current asymmetry. Many fixed income instruments now generate meaningful yield without the risk of capital loss. We favour quality and shorter duration.
• Alternative Assets: Owning assets with collateral-based cashflows, brings diversification to portfolios. We favour being selective across this broad and diverse area, favouring quality and doing thorough due diligence.
• Cash: With an uncertain outlook and risk-free rates of 5% available, we have not been surprised to see cash allocations increasing. We see a logic in keeping some cash as dry powder for tactical and opportunistic deployment.
• Currencies: The DXY Index has risen by more than 3% over the past quarter helped by relative US economic resilience and the rise in US Treasury yields. Strength may endure in the near-term, impacting other currencies negatively.
• Gold: We continue to see an important role for gold in portfolios. Recent price weakness has been a function of a stronger Dollar and higher real yields. For us, gold can continue to act as a hedge or buffer against market volatility.

Nobody ever said it was going to be easy. 2023 to-date has confounded most policymakers, economists, forecasters, and investors. Equities are up, but their performance has been markedly distorted by a very limited number of stocks. US Treasury yields are the highest in more than 16 years. The US economy continues to show apparent resilience, while others around the world have not been so lucky. Against this background, when Jerome Powell – arguably the voice others listen to most to get a sense of direction, in his role as Chair of the world’s most significant Central Bank – admits to uncertainty and confusion over the direction of travel, what hope do the rest of us have?

In one sense, the admission from Mr Powell shows remarkable humility. We are mere mortals trying to make intelligent strategic decisions. The data the Fed sees (and he stresses the importance of looking at its “totality”) are, if anything, superior to the average reader of this piece. The conclusion we draw is that caution and diversification are merited. There can be benefits in adopting a contrarian stance. At the least, we believe it’s important to question casual complacencies.

Both equities and bonds have generated losses over the past quarter (in the former of lower prices and higher yields respectively), perhaps a sign that not all is well. Sure, some of the motivation for the move in the former may be a function of profit-taking in certain over-extended segments of the market, notably mega-cap tech businesses. Nonetheless, there appears to be a growing realisation that higher (interest rates) for longer will be the order of the day in the US.

The historic approach adopted by Central Banks in rate cycles is to tighten until something breaks. For the Federal Reserve, there is no obvious upside from giving up too early. Listen to Jerome Powell and the other members of the FOMC and there is an acute consciousness of wanting to avoid the mistakes of the 1970s. There’s also the admission of how difficult the job is: “we don’t understand much about inflation” said Mr Powell in his latest press conference. To the extent that inflation can be interpreted, 12 of the 19 members of the FOMC have signalled via their ‘dot plots’ (or interest rate projections) that there will be one more hike before year-end. The Fed stresses that these projections constitute a survey and not a forecast. Nonetheless, the subsequent price action in equities and bonds suggests that the investment community does not like the upward shift in median interest rate projections. Forget a pivot towards lower rates any time soon.

The stance taken by the Fed could be seen as laudable. They appear committed to doing the right thing, even if not the easy thing. There is also a certain asymmetry in the Central Bank’s approach: while they may not look to ease immediately in the event of lower inflation, there is a likelihood of further hikes should current economic robustness endure. The problem with this approach is whether investors are prepared, or to put it another way, what’s discounted.

It would be naïve to assume that 11 rate rises in the last 16 months won’t have an impact at some stage, both in terms of crimping consumer demand and impacting corporate margins. Perhaps no surprise that cash allocations are rising among Fund Managers (per Bank of America Merrill Lynch’s latest survey), but we see a major disconnect in the Bloomberg consensus assumption for ~10% earnings growth for both the S&P 500 Index and the MSCI World Index in 2024. How this may be achievable in the context of sticky inflation, swollen inventories and increasingly drained consumers remains to be seen.

There is an alternative way of interpreting things. Sure, look at the headlines, and investors have perhaps understandably taken fright at the seemingly more hawkish stance of the Fed. Analyse the details though and its forecasts for economic growth are now higher than a quarter prior. Might it just be possible that the Central Bank is able to reduce inflation without provoking a recession? Only time will tell. At the least, the path to any potentially promised soft landing for the economy will be a very narrow one.

Economic resilience has been surprising to most. It’s certainly been helped by loose fiscal policy. Our view, however, is that all good runs have to come to an end. Put simply, the benefits of fiscal stimulus will diminish and the impact of monetary restraint will begin to intensify. Investors need to realise that policy decisions do have costs, as evidently manifested in terms of higher interest rates and growing budget deficits.

The latest details are not encouraging. The US Conference Board’s Leading Economic Indicators have now fallen for 17 consecutive months, the longest stretch since the 2007-2008 Great Financial Crisis. Weak orders and tight credit conditions are both cited as concerns. Other data (from Moody’s) suggest that more Americans are falling behind on their car loans and credit card payments than at any time in over a decade. With 30-year mortgages at 7%+, it’s easy to see how home sales and building activity could take a leg down. Consider too that generally it is the corporate sector and not the consumer that drives recessions. Watch for leverage, this is the culprit. When many (especially smaller) businesses come to the refinancing of their debt at higher interest rates next year, there may be problems. Then there is the government budget deficit, which sits at 8% of US GDP, double its long-term average and not far from 2008 levels. $12tr of combined fiscal and monetary stimulus since the start of the pandemic is simply not sustainable,  particularly in a world of high interest rates.

We could point to multiple other headwinds: auto worker strikes (work days lost to stoppages in the US are at their highest in 25 years according to the Bureau of Labour Statistics), the inflationary pressures that a rising oil price could stoke, the resumption of student loan payments and the complications that would arise from a potential US government shutdown. Forget a soft landing, what about a perfect storm? In this narrative, imagine how the economy would fare in a world with less fiscal stimulus, slowing growth and the long, variable lagged impact of monetary policy. Add into the mix Eurozone stagflation and China’s debt crisis and the scenario of a synchronised global slowdown might not seem so far-fetched.

Cycles are, of course, hard to read when you’re living inside them. Often, it’s easier said than done to call recessions. It’s also naïve to assume that crowds in markets have (any) wisdom. Perhaps we should listen more to Jerome Powell. Notably, he used the word “careful” more than almost any other in his last press conference. We think the correct stance in the current environment is for investors to recalibrate their expectations, especially for equity returns in a higher rate environment.

With equity and bond correlations increasing, diversification is crucial. Such a view is reinforced by what we see as the new world reality. We are living in a world of structurally higher inflation (versus prior cycles), impacted by a combination of fiscal stimulus tools, labour shortages, global energy transitions and heightened geopolitical tensions. Relying solely on one asset class (equities or fixed income) makes little sense. Add diversification to lower portfolio risk.    

Alex Gunz, Fund Manager, Heptagon Capital