View From The Top: Regime Change
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: Vladimir Putin wants a new regime in Ukraine. Many in the western world hope for similar change at the Kremlin. While both are dominating headlines, neither may happen. Investors, however, are beginning to realise that regime change is a very real phenomenon. Gone are deflation, declining bond yields and dovish Central Banks. In their stead is the most pronounced inflation in a generation and a correspondingly more hawkish Federal Reserve. The benefits that globalisation brought about are also clearly in reverse. Deglobalisation is inherently inflationary. Asset allocation strategies therefore need a marked rethink. Previous sources of return will not be the drivers of future gains. Forget conventional 60:40 equity-fixed income strategies. While there may be little alternative to equities for those looking for mainstream assets with liquidity, our continued counsel remains one of proactive diversification, especially into uncorrelated areas. Own gold and commodities too.
- Equities: Global stock market indices have benefited markedly from fixed income outflows. Many equity benchmarks are now higher than before Russia’s invasion of Ukraine, with the S&P 500 Index less than 6% below its all-time peak. Earnings yields generally remain above comparable bond metrics. Equities, however, are not immune to inflationary pressures and earnings revisions have turned negative in the US for the first time since September 2020 (per Bloomberg). Choose selectively. Europe is most exposed to Russian risks. Our preference is for global businesses with pricing power. Also embrace a range of styles for diversification: growth and value, quality and cyclical.
- Fixed Income/Credit: The year-to-date performance of Bloomberg’s US Treasury Index is the worst since series data began in 1973. Globally, the picture is similar (the indices are down more than 6% and 10% respectively). In the face of markedly higher inflation trends, bonds have not demonstrated any perceived safe haven benefits. We are still some way from yields (relative to equities) being at sufficient levels to make owning fixed income in general compelling. Elsewhere in the credit complex, we note that spreads are widening (in both the US and Europe) and high yield default rates rising. Our allocations remain very limited and highly selective for now.
- Gold/ commodities: Our positive stance on this asset class continues to grow, particularly given the current geopolitical backdrop of supply constraints combined with growing demand. Accelerated energy transition strategies by western governments will also be supportive to this dynamic. Gold and commodity assets also tend to outperform in more inflationary environments and could further be considered to represent a store of value in times of greater stress.
- Alternative Assets: We reiterate our stance of increased allocations towards this space. Take advantage of still-low real interest rates to gain exposure to hard assets. Collateral-backed cashflows are attractive since they can act as an additional inflation hedge. Favour business models with strong balance sheets. Look to real estate, infrastructure and logistics.
- Currencies: Recent events have reinforced the strength of the US Dollar as well as its safe haven currency positioning. Both the Euro and Yen are at corresponding relative lows. Fed tightening may lend further support to the Dollar in the near-term.
To suggest that the opening quarter of the year has been an eventful one for investors could almost be considered an understatement. There’s been the first hostile invasion of another territory in Europe in over 75 years, provoking the most significant European humanitarian crisis since 1945 and forcing all countries to reassess their geopolitical priorities. We also have the most pronounced inflation since the early 1980s and many Central Banks moving in a correspondingly more hawkish direction. In addition, coronavirus – the major concern for many of the last two years – has still not fully disappeared. Such an unappetising combination of factors inevitably has created a challenging backdrop. Overall, this is probably the worst macro set up we have seen in some time. Sure, the recent reset has made valuation levels more compelling, but the outlook remains clouded with uncertainties. And, we haven’t even begun to talk about the possibility of stagflation yet…
What we’re currently witnessing is the bursting of the everything bubble, or an end to the massive uptrend in large cap growth (versus value); an exodus from the most crowded areas of the market. While the causes of this phenomenon might be multiple, there is no doubting that there has been a massive pivot on the part of the Federal Reserve. Consider that only three months ago, no member of the Fed’s Open Market (or rate-setting) Committee thought rates could go beyond 2.25% by the end of next year. Now, almost all of them think rates will go at least to that level and some as high as 3.75%. This is arguably the biggest shift from one meeting to the next in the decade that the Fed has been sharing the dot plots. Investors have not had to contend with a more hawkish Fed for quite some time. Indeed, many have no experience of a world without falling rates. No surprise then that cash levels are at their highest since March 2020 (per Bank of America Merrill Lynch’s latest Fund Manager survey). Risk assets may not do so well when Central Banks turn more hawkish.
The clear messaging from the Fed is that it will take the “necessary steps” to get inflation under control. Seven more rate hikes for the US are currently being priced in for 2022. Have no doubt, the Fed’s priority seems to be to fight inflation at any cost. With mid-term elections pending, there is also perhaps a quasi political imperative to be shown to be protecting consumers already suffering from a higher cost of living. The major worry is that such an approach – if the Fed digs in to fight inflation – might trigger a recession. An inverting yield curve (i.e. where short rates are above long rates) is perhaps most indicative of investors’ conclusion: the Fed is making a mistake in its policy; it has gone (or will go) too far. The 30-year/5-year Treasury curve inverted towards the end of the March for the first time since 2006. Neither the more-watched 10-year/2-year nor 10-year/3-month curve has inverted yet, although it may only be a matter of time.
Of course, even if the ‘this time is different’ argument can be deployed (owing to the last decade and more of unconventional monetary policy and the unprecedented nature of the coronavirus pandemic), we shouldn’t discount the predictive ability of the inverting yield curve. The Fed’s hope remains that it can engineer a soft-landing. Listen to Jerome Powell’s optimism: the US “can handle” tighter monetary policy and avoid a recession. Sceptics might justifiably respond by suggesting that perhaps the Fed doesn’t have a clue, given its recent major shift and the dissension that is evident among its members over the future direction of policy.
Regardless, it’s hard to ignore that yields all along of the curve are markedly higher than they were pre-pandemic. 10 year US Treasuries currently stand at 2.34%, a huge shift from the 1.82% level recorded at the start of the month. It’s also abundantly clear that virtually every measure of inflation is still rising. The last recorded US print of 7.9% (up 40 basis points month-on-month) is the highest since January 1982. Core inflation accelerated at a faster pace, to 6.2%, while the Atlanta Fed’s most recent reading of ‘sticky’ inflation stands at an uncomfortable 6.5%. Further, five year US inflation break-evens (a good proxy for future inflation) are at their highest in 20 years. Longer-term expectations, looking out over 10 years, have broken above 3% for the first time. In Europe, inflation is at its highest in eight years and even Japan is recording its strongest prints since 2018. To his (very minor) credit, Jerome Powell does seem to recognise that the story of inflation peaking later this year has “fallen apart.”
The good news is that GDP growth for now looks fine, particularly given the health of the US jobs market (rising wages and participation rates). However, it is hard to ignore the fact that higher inflation will eat into consumer disposable incomes and hence could trigger a slowdown in economic activity. Meanwhile, the latest Michigan consumer sentiment survey hit a new post-GFC low last month. It is also worth considering that inverted yields curves may do more than signal recessions; they may also cause them. Financial institutions will naturally be less willing to lend when short rates are higher than long ones, which could precipitate economic contraction. Other factors of concern include US home sales down more than 20% year-on-year (an indicator which often portends recession) and evidence that credit spreads are widening, in both the US and Europe.
There is also the more structural worry of what’s happening in Ukraine. Think of Russia’s invasion as a significant and potentially permanent blow to the globalisation of capital, not to mention the major refugee crisis it has triggered. What we are arguably seeing emerge is a tripolar world, where the objectives of the United States, Russia and China will likely differ markedly. At the least, there has been a collapse in global trust and, at worst, there is the potential for an (inflationary) arms race.
In the nearer term, the invasion of Ukraine is unleashing the biggest commodity shock since 1973. Although Russia may only account for 2% of the world’s GDP, it is a leading global producer of oil, natural gas, industrial metals, wheat and fertilisers, with global shares of at least 10% in all categories. An overall index of world commodity prices is now more than 25% higher than at the start of the year (all data per Reuters). Supply chains almost everywhere were already pressured and have yet to recover fully post-pandemic. The ratchet has now turned higher. Little wonder then that global inflation is running at 7%. Almost every forecasting agency has responded to this dynamic by cutting its 2022 and 2023 GDP growth estimates. High energy and commodity prices will work to slow down the economy. Against this background, tightening monetary policy into an economic deterioration is unlikely to be a good outcome. It may be too early to talk about stagflation, but the world is set to be entering a period of above-trend inflation and below-trend growth.
However, there are clear reasons for optimism. Equity markets around the world have rebounded strongly in the last month and are comfortably higher than pre-invasion levels. Fixed income investors, of course, have not been so fortunate. To the extent that the Fed has done its job properly, then it has been in convincing investors that it is serious about tackling inflation. Relative certainty over the course of Central Bank action can be considered a good outcome from an equity perspective. If real yields are negative while inflation is rising, then equities clearly also provide a cheaper hedge (or will lose relatively less value) than conventional fixed income. Meanwhile, with some 30% of the S&P 500 Index and over 50% of the NASDAQ Composite Index having reached correction territory during the past month (pre- the market’s bounce), it would be fair to contend that previous bubbles now look considerably less pronounced. Peace or even a ‘grey swan’ event such as a coup in Russia and the deposition of Vladimir Putin would bring considerable relief, but it probably won’t cure inflationary concerns.
Ultimately, it may be no more complicated than the notion that there is no (meaningful, liquid) alternative to equities. At the least, it should be abundantly clear that from a portfolio construction perspective, the traditional 60:40 model no longer works. A Bloomberg composite index that tracks the performance of such an equity-bond portfolio is down over 10% year-to-date, its worst annual showing since 2008. We can only reiterate the importance of diversification. A world where interest rates are not falling is harder for all investors. Against this background, it is fair to contend that the sources of future return will be very different to those of the past. Diversify portfolios or risk facing lower returns.
Alex Gunz, Fund Manager, Heptagon Capital
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