View From The Top: The deadly hitman
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: despite the tumult, things can clearly get a lot worse. Quantitative tightening has barely begun and US rate hikes haven’t even started yet. Central Banks are facing “the deadly hitman” of inflation (per Ronald Reagan). The term also has a certain validity when considering the geopolitical instability currently being wrought by Russia in Ukraine. Even if this perfect storm of events (not forgetting elevated valuation levels in many assets) may not be conducive to either growth or risk, there are clear reasons for optimism. Our sense is that a lot of bad news has been priced already. With real yields so low, financial conditions remain very easy, while an economic recession does not currently look imminent. What we do know is that the sources of return for investors going forward will likely be very different to those that have worked in the past cycle of monetary accommodation. Now is a time to remain calm and seek to diversify. From crises, opportunities often emerge.
- Equities: The MSCI All-Country World Index has fallen almost 8% year-to-date. While the fourth quarter earnings season was generally encouraging, the rate of earnings growth will slow markedly over the remainder of this year. Guidance from corporates in the US is currently at its most cautious in more than a decade. Previous levels of equity returns enjoyed in the past decade are unlikely to be repeated in the near-term. However, we still prefer equities to fixed income. Recent market volatility means that clear opportunities are developing within certain spaces. General uncertainty should allow truly active and differentiated managers to prosper.
- Fixed Income/Credit: Yields have moved significantly since the start of 2022, but the massive shrinkage in negative yielding debt (equivalent to over $10tr in the last three years) would suggest that a lot of the regime change to higher interest rates and tighter policy has already been somewhat priced. Investors remain hungry for yield. At some stage – but not yet – the yield on debt relative to equities will make it more compelling to own. 10-year US Treasury debt passed a 2% yield for the first time since 2019 intra-month, but was at 15% last time inflation was this high. Our positions remain limited. Stay on the sidelines for now. Avoid high yield given its sensitivity to the business cycle.
- Gold/ commodities: We have had a positive stance on gold for some time and advocated the case for increased exposure to commodities more generally at the start of the year. These assets are currently outperforming since they represent a clear store of value in times of stress. Think of them as an ongoing hedge against geopolitics coupled with a clear benefit delivered from offering in-built inflation protection.
- Alternative Assets: We reiterate our stance of increased allocations towards this space. Take advantage of low real interest rates to gain exposure to real 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: Safe haven currencies such as the Swiss Franc should benefit from a risk-off environment. Meanwhile the Dollar may continue to enjoy further support from the Fed leading (relative to other Central Banks) in the hiking cycle.
Global markets have certainly had a lot of bad news to digest in a very short period. However, the current environment is not conducive to a sustained advance in risk assets, even if many equity indices have already gone through deep corrections and/ or stealth bear markets. The worst time for markets is at turning points, whether from (broad) global geopolitical stability to instability, or from extreme monetary accommodation to a process of tightening. Key considerations at this time would be: stay calm, avoid emotion, don’t panic and recognise that long-term opportunities will emerge.
Where we’re at currently constitutes a perfect storm of war in Ukraine, rising rate concerns and stretched valuations. Unsurprisingly then, it has been the worst start to a year for many assets in a long time. Almost a fifth of the S&P 500 Index’s constituents, over 40% of those in the NASDAQ Composite Index and close on 60% of those in the Russell 2000 Index have seen share prices corrections of more than 25% from their highs (per Bloomberg). Investors are apparently their most bearish on tech in 16 years (per the latest Bank of America Merrill Lynch Fund Manager survey). The same study shows that Fund Manager cash levels are at their highest since May 2020, when the pandemic was first beginning.
Beyond war in Ukraine, investors are having to contend with the most aggressive Central Bank pivot in a generation. The world is being weaned off easy money at the same time that fiscal support is being withdrawn. Whether correctly or not, the market is pricing at least six Fed interest rate hikes (and a similar number by the Bank of England) before the end of the year. The disconnect arises from the fact that the ‘dot plot’ – or forecasts made by the members of the Fed’s Open Reserve Committee – calls for just three rate rises this year. A three-hike divergence is considerable and indicative of just how much the former perceives the latter to be behind the curve. The problem is further exacerbated by the fact that the Fed has given no indication it will change course until either inflation has peaked or financial markets have truly capitulated. So adios ZIRP and all its implications. Put another way, the unwinding of the monetary experiment of the last decade will be painful. No surprise, then, that investors are on edge.
The main reason for the abrupt change in Central Bank policy can be summarised in just one word: inflation. As Ronald Reagan – US President when inflation was last this high – famously remarked, it is “as deadly as a hitman, as violent as a mugger, as frightening as an armed robber.” The same observations could, unfortunately, also be applied to Vladimir Putin’s current course of action. Quips aside, the facts are stark: global inflation stands at 6.0%, while a reading of 7.5% in the US marks a 40-year high. House prices (up 18.8% year-on-year) in the US are rising at their fastest rate since 1987 while wage growth has exceeded an annualised rate of 5% for the first time in over 20 years (all data per Bloomberg).
The bigger problem is that when you ask US households (and probably those in many other developed world nations currently) what their current largest concern is, then the answer that comes back is unambiguous. Per a recent Gallup poll, forget COVID or Russia, it’s inflation. Only 9% of Americans interviewed said that they expect inflationary pressures to improve in the second half of this year. The University of Michigan’s monthly study forecasts consumer expectations for inflation at 5.0% in the US one year out and 3.1% five years out, the highest figures since 2008 and 2011, respectively. The issue, to our mind, is less when inflation burns out – perhaps as supply chain constraints ease – and more when consumer expectations and behaviour change. This may take longer. Needless to say, with US mid-term elections on the horizon, the political pressure is significant. We also shouldn’t forget that sanctions imposed upon Russia may only add metaphorical fuel to the inflationary fire, particularly since Russia is a major supplier of fertiliser globally, which could result in pushing up further already-elevated food prices.
Things can get a lot worse. Quantitative tightening (or balance sheet shrinkage) has barely begun and US rate hikes haven’t even started yet. Bear in mind that no G7 Central Bank has set interest rates at over 2.5% in more than a decade. For context, however, back in 1990, rates in all seven countries were over 5%, while the last time US inflation was at over 7%, the Federal Funds Rate stood at 15%. Should the Fed get to 1.75% by the end of 2022 – i.e., what is effectively being discounted – then this would constitute the most hiking the US Central Bank has done in a year since 2005. The Fed’s priority – as it has made abundantly clear – is to tame inflation, and this trumps any move in asset prices for now. Perhaps we may have to live with equity market turbulence.
While history is not necessarily any guide to the present – particularly given the extreme monetary experiment that has been conducted in the last decade or so – there are very few examples of Central Banks calming inflation without the economy suffering a recession. The Fed has a poor track record in managing ‘soft landings.’ Additionally, Jerome Powell and his fellow Committee Members have given no clear indication yet under what circumstances they may blink – most likely not, in our view, until the Fed’s actions clearly start impacting economic growth. We should also not forget that even if inflation prints do ease as the year develops, a more structural set of factors could mean that we will have to live with inflationary pressures for some time. COVID-related inputs (stretched supply chains, for example) are, arguably, giving way to decarbonising priorities coupled with a world that has deglobalized. Both of these drivers imply a fundamental resource reallocation coupled with upward prices.
One other factor that investors need to consider is that earnings will not escape unscathed from current dynamics. We have just passed the last quarter of super-easy COVID-related comparisons. Put another way, four consecutive quarters of 30%+ year-on-year earnings growth for the S&P 500 Index will give way to 5.5% growth in Q1 and 4.8% in Q2 (per Factset). Further, against a backdrop of inflationary pressures and still-constrained supply chains, current corporate earnings guidance from S&P members is the worst it has been since 2009 (per Bloomberg).
Nonetheless, there are reasons for optimism. A lot of bad news has been priced already. Think of it this way: inflation transition and hawkish Central Banks mean that the proportion of negative yielding bonds (as a total of all bonds issued) has fallen from ~25% at peak to ~5% currently. In monetary terms, this has been equivalent to a 70% reduction, from $18tr three years ago to $5tr at present (per Bloomberg). This shrinkage is indicative of the extent to which the market has already repriced higher rates. Further, it is still not clear whether the market and/or the economy will allow for tightening on the scale discounted. The Fed has repeatedly changed course and Jerome Powell’s get-out clause is that his actions will be data-dependent. He will be “humble and nimble.” The Fed as well as investors clearly have their eyes on the shape of the yield curve and would most likely seek to try and avoid any possible inversion. Equity bear markets occur less when the market fears the Fed and more when investors fear recession. Fortunately there is little sign of the latter presently.
Turning points, by definition, create opportunities. This cycle is clearly different to others, not only because valuations are currently elevated (in general terms), but also since interest rates are moving off secular lows. As a result, the drivers of returns and leadership should be very different to in previous cycles. The 15%+ annualised returns that global equities have delivered over the last five years are unlikely to be repeated any time soon. If investors want comparable returns, then they will need to branch out beyond the conventional. Against this background, diversification and a focus on generating true alpha has never been more important.
Alex Gunz, Fund Manager, Heptagon Capital
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