View From The Top: That tightening feeling

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: have no doubt, the world is moving towards a tightening cycle. Sure, this is occurring at just the time when economic growth rates are decelerating. However, it’s important to recognise that GDP going into 2022 will remain well above trend levels. The markedly larger concern currently is inflation. The transitory versus permanent debate may not resolve itself any time soon, but we do see increasingly clear evidence that supports the notion of higher inflation (expectations) becoming more entrenched. There has been a marked change in inflation psychology. Positioning needs to adapt. Regime change means that conventional 60:40 bond-equity allocations will be increasingly challenged. Elevated valuations for many asset classes also necessarily imply lower future returns. Our response is to preserve balance but to favour the undervalued and the uncorrelated.

Asset Allocation:

• Equities: Stock indices globally stand at close to all-time highs, even after September’s price action. At the same time, valuation levels also remain elevated, surpassed only by the TMT bubble on some metrics (such as cyclically-adjusted earnings). Against this background, value as a style looks relatively well-positioned. Equities globally should deliver c15% earnings growth in 2022 (on Bloomberg estimates) which will continue to provide support for their case, especially relative to fixed income. We favour a balance: embrace value and cyclicals as well as quality growth.
• Fixed Income/ Credit: The yield on 10-year US Government Debt has moved to c1.5% levels for the first time since June. Comparable yields on 2-year and 5-year debt are at their highest in 18 months. The prospect of more entrenched inflation and correspondingly tighter policy provides the best explanation. Nonetheless, over $14tn of all government debt is still negative yielding as is a large portion of IG and HY debt. At the same time, large portions of more speculative paper is deteriorating in quality (based on ratings outlooks). We still favour only limited allocations to this broad class.
• Currencies: Dollar strength is the order of the day, with the currency at its highest levels since November 2020 relative to baskets of both developed and emerging market peers. Such a move may be explained by the more hawkish recent shift in Fed policy. The trend may continue for some time even if the magnitude of America’s fiscal and trade debt burdens would argue for mean reversion over time.
• Alternative Assets: We favour increasing allocations to this space since these assets bring clear diversification benefits to portfolios. We are also attracted to the collateral-backed cashflows that these assets generate. We expect infrastructure assets to benefit from ongoing fiscal stimulus initiatives. We also advocate exposure to business models with strong balance sheets such as seniors’ housing or logistics REITS.
• Gold: We see a continued place for gold in investor’s portfolios, even if its performance in 2020 has been lacklustre. Gold constitutes both a very good additional portfolio diversifier and also as a low-cost portfolio hedge.

We’ve been overdue a setback. Global equities ended September 4.3% lower. One could hardly argue this is a major cause for concern given that this constitutes the first down month for markets since January 2021. Further, there has not been a peak-to-trough decline of greater than 5% since last year’s US Presidential Election. The MSCI World is just 5.2% away from its all-time high. Why the potential panic, then? Put simply, the current risk-reward set up is uncompelling, while elevated valuations serve only to increase market fragility. Many major asset classes are vulnerable to any hint of bad news; there is very little buffer to counter negative surprises. Such an impression is only confirmed by having met with over 20 investors in the past month (both in the real world and virtually). In almost every meeting valuation concerns arose as a topic of major discussion.

There are two available interpretations to the fact that equity markets fell as little as they did in September, particularly with the prospect of decelerating earnings combined with the likely commencement of tapering/tightening in to come. The positive one might be that investors will take these developments in their stride, as they have done with most other more adverse news over the past 18 months. Alternatively, the robustness in equities may smack of complacency. Risks are being ignored at one’s peril. We have argued for some time about regime change (from deflation to reflation and relative growth to value) as being real. The questions which arise are simple: where do we go from here, and how to position?

To answer these, we need to consider the outlook for both growth and inflation. Spoiler alert, the bigger risk lies in failing to understand and manage the latter appropriately. Begin with growth though. Expectations are coming down, gently but steadily. This is a function of negative economic momentum; the data are worse than expected. Multiple (exogenous) factors are at work here. In no particular order: the Delta variant of the virus remains virulent (the World Health Organisation reports still close to 700,000 confirmed new cases and 10,000 fatalities daily), supply chains remain constrained; energy prices are spiralling; and the Evergrande property crisis is having an impact on Chinese confidence. Have no doubt, the recovery is supply-constrained with Delta deferring demand. Before we panic, however, to defer demand is not to destroy it. Projected GDP growth of 4.3% for the US and 4.2% for the Eurozone for 2022 (on Bloomberg consensus estimates) is, of course, slower than 2021 levels (5.9% and 5.0% respectively) but remains well above trend levels.

The other way to frame this debate is to consider the role of Central Banks. Sure, it can be argued that the task of withdrawing stimulus is made more difficult by the myriad risks facing the global economy. Nonetheless, investors can take some comfort from the expectation that if growth were to falter materially, then the Fed et al may come to the rescue – again – with more stimulus. On the other hand, should inflation prove to be anything other than transitory then we may have a problem. In a scenario either where it takes off and the Fed sits back or it has to raise rates abruptly, then the risk of a financial accident is high. Of course, the cynics’ argument might be that a reset is just what investors need, particularly in the context of peak everything.

How much trust to place in the powers of Central Bankers remains highly open to debate. It is hard to know at present the extent to which investors believe Jerome Powell when he asserts – with some regularity – that inflation is just transitory. It is easy towant to believesuch a view since it supports the current bias in positioning vis-à-vis both equities and fixed income, which would necessarily continue to benefit from a low rate environment. At the very least, in our view, the debate between those in the transitory and permanent camps is not going to be resolved any time soon, especially since we cannot yet place the pandemic in the past tense.

We should perhaps let the facts speak for themselves. US CPI inflation stood at 5.3% in August, more than three times its post-GFC average (the ratio is similar in the Eurozone). Further, the New York Fed’s inflation gauge for that month stood at 4.3% – a 25-year high. This gauge is designed to measure a broader range of prices than the conventional CPI metric. It is also of concern that there is currently a greater than 400 basis point spread between input prices and inflation. This augers badly for future inflation. Input prices in the US are their highest since 1981.

Should the factors driving these metrics be just transitory, then there would be no major cause for concern. What worries us, however, is that there is mounting evidence to the contrary. With US unemployment now lower than CPI for the first time since 1990, average hourly earnings are continuing to rise. They are currently over 1.4 standard deviations above their mean for the past decade, with 57% of firms saying that they plan to boost wages by at least 4% in the coming 12 months (this latter data point from the Philadelphia Fed; the remainder courtesy of Bloomberg). Wage-price spiral, anyone? Not dissimilar to the pandemic’s virus, inflation can be very contagious. More data from the New York Fed show that 1-year inflation expectations in the US are at their highest since their series began in 2013. They stand at 5.2%. Looking out over the next 3 years, consumers see inflation at 4.0%, 30 basis points higher than the month prior. Needless to say, once consumers start to factor in higher inflation (expectations), the longer it will take for (actual) inflation to come down; a vicious circle effect if ever there were one. At heart, it is very difficult to deny that there has been an undoubted change in inflation psychology. The challenge is for positioning to catch up with this dynamic.

This altered mindset also provides a very good guide, in our view, for the Federal Reserve’s more hawkish turn/ tone, enunciated in the past month. Even if tapering policy has been separated from tightening policy, a ‘tightening tantrum’ is still more than possible. The Fed is far from alone in its course of action. Brazil, Norway and South Korea have all moved rates up in the past month and recent messaging from both the Bank of England and Bank of Australia is consistent with that of the Fed. Globally, the balance between those Central Banks tightening and loosening globally is more skewed towards the former than it has been at any time in the past decade (per analysis from Deutsche Bank).

In some fashion, the world is moving towards a tightening cycle. If growth is only slowing (rather than outright faltering) and inflation is more entrenched than perhaps Central Bankers want formally to admit, then this strategy is highly logical. The longer you delay hawkishness, the faster Central Banks will have to move once inflation really does become entrenched. The valid concern, of course, that arises from such an approach is that there is a clear risk of policy error – tighten too fast and you risk undermining the economy. Nonetheless, investors are going to have to live with proactive Central Banks; they appear adamant that they do not wish to set idle.

How, then, to position? A weakening economy can keep bond yields low and prop up stocks, but rising inflation will distort this picture. At the least, the 60:40 bond-equity default playbook looks increasingly irrelevant. There is also a certain complacent stasis in the positioning of those Fund Managers interviewed by Merrill Lynch: 75% are overweight equities and 69% are underweight fixed income, per last month’s survey. It’s hard to rebut the idea that equities remain cheap relative to fixed income, but stock market corrections have the greatest tendency of occurring when valuations are elevated – which few can argue against currently. There’s also the inescapable issue that high starting points for many asset classes necessarily imply lower future returns. Sure, a general pullback might allow for the chance to increase exposure, but our approach is to favour the obviously undervalued and uncorrelated.       

Alex Gunz, Fund Manager, Heptagon Capital