View From The Top: Sunny times
View from the very top: Everyone is now seemingly bullish. Sceptics are harder to find as risk assets have continued to rally. A soft landing for the US economy has become consensus opinion. Inflationary threats are in the rearview mirror. While it is hard to disagree with the above notions, we believe that there may be a case for adopting a somewhat more contrarian stance. Just as the first half of 2023 had its fair share of surprises, so may the remainder of the year. The forward path for inflation may well be non-linear, while the lagged impact of interest rate hikes may yet kick in. Tighter financial conditions may also provoke more defaults. Hence, our positive perspective is nuanced with a slightly more defensive near-term tilt. Our sense is that if equities are currently over-bought, then fixed income is arguably oversold. More broadly, do not abandon all caution. Thoughtful risk management and asset allocation are key to long-term investing success.
- Equities: Global markets are at or close to all-time highs. This follows the erasure of all of 2022’s loss in US equities (per the S&P 500 Index) in less than 10 months. At the same time, the NASDAQ Index has posted its best ever start to a year. Against this background, there may be a case for a pause, particularly in the context of more elevated valuation levels combined with broadly flat earnings estimates. The ongoing Q2 reporting season may prove a reality check for some businesses. More positively, we see growing opportunities for stock pickers, with both mean reversion and as the market rally broadens beyond big tech. We favour active equity strategies across a range of styles: growth and value, quality and cyclical.
- Fixed Income/Credit: If history is any gauge, when inflation peaks, so do bond yields. Improving inflation metrics should therefore be good for fixed income. Investors also benefit from an attractive starting point, given the major drawdown that occurred in bond markets globally in 2022. The monthly Bank of America Merrill Lynch Fund Manager Survey shows investors have moved to overweight positions in fixed income for the first time since the 2008 Financial Crisis. High yield should also benefit from lower inflation, but our approach emphasises keeping it simple and favours owning high-quality credit (both government and corporate). We believe that adding some duration currently makes sense.
- Currencies: Since the Dollar’s peak in September 2022, it has fallen by ~13%, a drop which continued in July. The DXY Index (which measures the currency against six others) is at its lowest since April 2022. We believe this trend could continue, particularly if the Fed does move towards a looser monetary policy stance. This would benefit EM currencies. Logically, currencies in regions where Central Banks are continuing to tighten may see further strengthening.
- Gold: Gold has enjoyed a double-digit return so far in 2023, and while the asset offers no yield, we continue to see a strong case for an allocation in portfolios. Gold can act as a hedge against geopolitical uncertainties as well as buffer against market volatility, particularly given its largely uncorrelated nature with (US) equities.
- Alternative Assets: We continue to see a case for owning assets with collateral-based cashflows, as a form of diversification within portfolios. Our stance has, however, always favoured being selective across this broad and diverse area. Commercial real estate remains a source of near-term risk in our view.
Enjoy it while it lasts: warm weather, vacation time, empty capital cities and buoyant capital markets. Investors seem increasingly convinced that the year-to-date rally in equities can prove enduring, especially if the US economy avoids recession and Central Banks avoid making policy errors. Our stance remains highly constructive towards risk assets – as it has been since the fourth quarter of last year – but we would nuance outright bullishness with a slight defensive tilt near-term.
Have no doubt, there has been a marked perception shift: from scepticism to admiration,as far as the rally in stock markets is concerned. The bear market in US equities has been erased fewer than 20 months after it began. Strategists have been left behind, as evidenced by the recent raising of year-end target prices for the S&P 500 Index. It would certainly be fair to recognise that the rally’s foundations are looking more solid, with performance broadening from the mega-cap tech names outwards. From our perspective, the upward move in equities is less about the hype around AI and more a recognition that the Fed’s policymaking framework will hopefully break neither the economy nor the financial system.
To take a step back, it is certainly an impressive achievement for the ‘everything bubble’ to have survived the return of inflation, rising interest rates, war in the Eurozone and the threat of recession. The US banking crisis of March seems long forgotten and the economy has managed to keep growing even with tighter monetary policy. Sure, broadly loose fiscal policy has helped as an offset, but the more important dynamic remains that of the emboldened consumer. Data from the monthly University of Michigan Consumer Confidence Index remain highly robust and recent commentaries from America’s largest banks paint a similarly benign picture. Beyond the consumer, there is clear evidence of a resurgence in corporate capital expenditure. The housing market is tight, with demand exceeding supply. US unemployment stands at a 50-year low. Arguably, these are the best of times.
Most remarkably, US inflation has fallen from over 9% to just 3% in less than a year. Core inflation (excluding food and energy) may remain higher, at close to 5%, but June’s month-on-month rise in this metric was the slowest since February 2021. When considering either the ‘trimmed mean’ or ‘sticky’ measures for inflation favoured by some forecasters, both these are trending in the right direction too. Looking forward, data from the New York Fed show that consumers’ median expectations for inflation in the near-term have fallen for three consecutive months and are at their lowest in over two years. With US producer price inflation at close to zero, implying that the entire COVID-19 era shock has been completely reversed on the supply side, the evidence looks increasingly compelling that the worst of inflation is behind us. Forget the threat of stagflation or hyperinflation; disinflation is the new buzzword.
Even with a 25-basis point increase in the Fed Funds Rate at the end of July, importantly if US inflation recedes again in July and August, then the Fed will be under increasing pressure to call time on its tightening cycle. The Fed Fund Futures market assumes a peak at around 5.5% in November, a rate of 4.7% in 12 months’ time, and discounts interest rates at close to 4% by the start of 2025. Put another way, six effective 25 basis point decreases in rates are being priced in for the coming 18 months. On this world view and should all grow right, then it is possible to envisage a scenario where 2024 is characterised be a reacceleration in economic growth and a rebound in corporate profits. Bottom-up Bloomberg forecasts for the S&P 500 Index assume -1% earnings growth for 2023, but almost 10% growth for 2024.
Before we get carried away with excess optimism, it is worth considering a contrarian perspective. Bubbles can, of course, survive for a long time, but equally, very few investors are good at calling either market tops or bottoms. Cycles – by definition – stem from excesses and corrections. Against this background, we think it important to watch for moments when people are so optimistic that they think things can only get better.
As we (and many others) have noted before: don’t fight the Fed. Almost every market perspective begins and ends with a view on US interest rates and inflation. Perversely, as investors begin to love the current rally more, the Fed may have reason to dislike it increasingly – why be responsible (and hence blamed) for creating an asset bubble? We believe that there would be little point in the Fed giving up too early. Against this background, there is a logic to err towards too tight rather than too loose policy, even if there are clearly risks attached to this approach. Were the Fed even to stay put with its policy for a lengthy period, then this could confound market expectations. Data-dependency remains a great get-out clause for most policy decisions.
Do not forget that the path for inflation may be non-linear. Victory on inflation is not inevitable and the timing of such an outcome is still uncertain. It would be both complacent and naïve to assume that there will not be blips along the way. Further progress may get harder. Even at ~3.0% in the US, inflation remains well above target. In the Eurozone, not to mention the UK, inflation is markedly higher. While space does not permit for lengthy discussion of economic dynamics in these regions, it would be fair to recognise that the return to economic normality here remains more distant. Even in the US and notwithstanding one-year forward inflation expectations (cited earlier), three-year forecasts are still anchored at 3.0%, a figure which has not budged in recent months. While the COVID-19 and Russia-Ukraine shocks may be in the rearview mirror, it is hard to dismiss the idea that both green economy and reshoring initiatives are structurally inflationary.
At the same time, the impact of prior rate hikes will likely slow the economy at some stage. Jerome Powell has talked regularly about “long and variable” lags. While some of this rhetoric may be simple expectations management, a Fed policy paper suggests that the currently most tight financial conditions in the US since 2008 could negatively impact GDP by up to 75 basis points this year. Further, even if recession is avoided, investors should be mindful of the debt storm brewing. It does not take a genius to see evidence for tightening lending standards. Combine this with liquidity being sucked out of the financial system (via quantitative tightening and the refilling of the Treasury General Account – both discussed in more detail in last month’s publication) and you have a potentially unappealing cocktail. Bloomberg reports that the number of corporate bankruptcies in the US year-to-date is the highest recorded since 2010, while Moody’s forecasts that global default rates could exceed 5% by this time next year, compared to a figure of 3.8% as of this June.
It may therefore pay for investors to tread carefully, especially since we have not even begun to discuss geopolitics yet. Further, before not too long the 2024 US Presidential Election will hove into view. The threat of a potential second term of Trump Presidency could prove destabilising for financial markets. As we noted earlier, bubbles can continue to inflate. This remains our default position. At the same time, don’t abandon caution: thoughtful risk management and asset allocation remain key to long-term investing success.
Alex Gunz, Fund Manager, Heptagon Capital
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