View From The Top: In a new land? Have a map.
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: focus on solutions rather than problems. Investor sentiment is poor as the world grapples with high inflation and slowing growth. It would be both incorrect and complacent to assume that policymakers will be able to manage appropriately through this challenging environment. Not only is their track record weak, but past playbooks may not work this time around. No two recessions are alike. Further, entrenched inflation will take time to dissipate. Most importantly, the world has changed. Debt, demographics and decelerating globalisation represent new difficulties. At the same time, the financial system is more interconnected than ever before. Policy decisions in one place have ramifications elsewhere. We therefore need a new playbook. Owning equities may be necessary, but is no longer sufficient. Sure, now is an appropriate time to be constructive towards this asset class: use general weakness as an opportunity to add. Equally, however, keep diversifying wherever possible and start to deploy dry powder judiciously.
- Equities: After a challenging first half, equity markets around the world have sought to establish a near-term bottom. The year-to-date story has been about multiple compression and, in this respect, it is now possible to make certain constructive arguments based around relative valuation. Earnings downgrades continue to represent a risk, particularly given historically high margin levels. The current reporting season has been mixed at best. We believe in the importance of stock selection and exposure to a range of styles (growth and value, quality and cyclical). While value has outperformed growth year-to-date, any shift in Central Bank policy (whether actual or perceived) could result in a rapid reversal.
- Fixed Income/Credit: Just as global equities reached a trough in mid-June, so too did bond yields (as evidenced by the US 10-year) peak at around the same time. For context, this was after the yield on Treasuries had doubled in the first half of 2022 and global bonds put in their worst returns in over 200 years. With much damage already done in bond markets, there are pockets of opportunity, particularly given the yields available from quality corporate issuers. Be selective, however: default risks will almost certainly grow should the economic backdrop worsen.
- Currencies: The strength of the US Dollar – at close to a 20-year high versus a basket of other developed world currencies – has been the most notable event of 2022. With the Euro having touched parity intra-month, we see a case for mean reversion near-term. However, Dollar strength may prevail over time, particularly given the more structural economic and policy challenges facing the Eurozone relative to the US.
- Gold/commodities: We continue to see a case for allocations to this space even though general commodity assets have declined from their peaks as recessionary fears have grown. We believe that exposure to this space helps provide a long-term hedge against inflationary and geopolitical pressures as well as bringing portfolio diversification benefits.
- Alternative Assets: There is a similar logic attached to owning hard assets. Collateral-backed cashflows can act as both an inflation hedge and a portfolio diversifier. We favour business models with strong balance sheets very selectively within the real estate, infrastructure and logistics spaces.
- Cash: The increasingly competitive yield on cash only increases its near-term attractions. We see a case for some allocations, particularly as a place to hide against a more uncertain macro backdrop.
August is the classic month in which to take a summer vacation. It will be much needed by many (your author included) especially after the dismal year-to-date returns from most asset classes. Sure, equities have rallied recently from their lows and bond yields have declined from peak levels, but only after the 16% loss that owning a conventional 60:40 equity-bond portfolio would have generated in the first half of the year (per Bloomberg). Even bear markets can have rallies.
Certainly if you listen to what investors are saying, then the outlook is gloomy, with global growth and profit expectations at an all-time low and equity exposure at its least since the market’s trough post the collapse of Lehman Brothers (per Bank of America Merrill Lynch’s latest survey). However, what investors are doing seems markedly different, as evidenced by ongoing flows into the market – for better or worse. Current sentiment is best characterised as confused, in our view. Brace yourself for more volatility ahead.
Our stance, however, is a constructive one: focus on solutions rather than problems. If there has been one key lesson from 2022 so far, then it is to listen and be flexible. A second useful piece of counsel is to recognise that the world has changed. Put another way, the past has only (extremely limited) validity as a template for the future. Decelerating globalisation strikes us as a secular trend and a reversal of the consensus for the prior 30 years. This has clear implications. At the same time (and perhaps ironically), the world is markedly more interconnected financially than it was last time inflation stood at similar levels. There is also notably higher retail investor participation (which has perhaps been partially responsible for ongoing equity market inflows) than in past cycles. What the Fed does therefore has much broader implications than ever before.
To return to the vacation metaphor, when you ’re in a new land and you’re unsure where to travel, what do you do? The answer is simple: get a new plan. Old playbooks simply don’t work. We accept that making novel or contrarian calls is cognitively difficult, but dedication to such an endeavour should deliver results. TINA – or there is no alternative to equities – has been the pervasive mindset since at least the commencement of quantitative easing post-financial crisis. As some other commentators have also suggested, this acronym could now be replaced by TARA: there are reasonable alternatives (to equities).
In the past, investors placed their hopes in the Central Bank ‘put’. These institutions would, as Mario Draghi famously put it, do “whatever it takes” to support both the economy and financial markets. This time around, it’s considerably more complicated. For starters, much of the inflation with which they are fighting has been generated by exogenous factors – higher fuel and food costs – that tighter policy can’t immediately cure. Closer to home, there are major constraints too. In the US, both public and private sector debt stand at levels double that of a generation prior, reducing room for manoeuvre. Consumer and small business confidence levels have rarely been this low, particularly not during a period of monetary tightening. At the same time, almost 90% of American voters (per a recent Axios survey) say that their first priority for Congress ahead of the mid-term elections is for it to fight inflation. Not an easy task. Over in Europe, the ECB has a different set of challenges: not only how to reconcile the multiple and conflicting economic needs of the Eurozone’s members, but also a region that is highly dependent on Russian gas. Political turmoil in Italy is also unhelpful.
The recent interest rate hikes by both the Federal Reserve and the ECB are, in many ways, irrelevant. Not only had they been broadly anticipated by the investment community, but what matters more is how Central Banks will respond to future data. Even though the consensus view is that inflation will fall, this is not how it has typically behaved. The recent past shows that it is difficult to trust much that Central Banks tell you (they said inflation was transitory…). Further, the market is often a poor gauge of inflation expectations, tending to over-simplify the relationship between growth and inflation, assuming there is a simple trade off between the two. There is also the practical consideration that interest rates only tend to impact the real economy twelve months after they have been implemented. Bulls are perhaps deluded by wishful thinking.
The same complacent consensus applies to the notion that the Fed et al. would be able to execute a perfect policy pivot in the event of a weakening economic backdrop. There are few – if any – examples of Central Bankers being able to manage successfully the business cycle throughout history. Some even told you that they had now eliminated the business cycle. Unfortunately, recessions do still occur. We may even be in a ‘technical’ one (i.e. two consecutive quarters of falling GDP growth) already, at least in the US. Regardless, as we’ve noted before, they can easily become self-fulfilling prophecies.
At the least, the world is in an exceptionally fragile place right now. Have no doubt, inflation lowers the affordability of everything, especially for the bulk of the population. This is a real problem. The recent profit warning from Walmart is indicative of the fact that all is not well with the US consumer (or large, listed corporates for that matter). And if you thought things were challenging in America, then consider the social unrest that inflation has already wrought in countries as diverse as Argentina, Kenya and Sri Lanka. More may follow. Inflation, it seems, is also driving demand destruction. A composite index of global purchasing manager activity is at a 26-month low, with indices in the US and Eurozone already signalling contraction. There is also growing evidence of corporate layoffs (or at the least, hiring freezes) beginning to accelerate.
Just as inflation expectations do not change overnight, so recessions are rarely shallow. Each is indeed different. A lot of ‘hope’, we feel, is built in already. The prevailing assumption is that any pending downturn is shallow and/or might be mitigated by Central Bank action. As we have noted already, policymakers are not infallible, however, and can quite easily make mistakes, especially since recessions generally do take time to unfold. There might also be the risk of a financial accident. Some pockets of the private equity market look over-leveraged. Certain areas of loan origination for US housing also look dubious. Don’t forget about the possibility of stagflation somewhere down the line.
The good news is that nothing lasts forever. Investors have also, to a certain extent anyway, begun to discount the possibility of a recession. Our counsel is to be constructive. Think of it as a subtle shift from selling on strength to buying on weakness. We know that it’s very difficult to time market bottoms and that both equities and bonds will remain vulnerable until growth/inflation improves. Equities do, however, tend to bottom before the economy does. With the S&P’s headline earnings multiple now back to its pre-pandemic low, many of the worst mistakes of the last cycle (e.g. Bitcoin) now repriced and the yield on 10-year US Treasury debt having rolled over from its 3%+ peak, there are reasons for optimism. Should the Fed consider pausing its policy tightening (either practically or via verbal signalling), then this could provoke a short-term rally. Other dynamics such as an easing of geopolitical tensions or a possible improvement in global growth (perhaps inspired by China relaxing its zero-COVID policy) may also help. It’s important though to think beyond equities. Owning equities is necessary, but not sufficient, in our view. Continue to diversify, particularly into uncorrelated assets.
Alex Gunz, Fund Manager, Heptagon Capital
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