View From the Top: The R-word

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…

View From the Top: The R-word

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: recessions are inevitable. They can also be good things, if they purge certain areas of the economy from excesses. After a challenging start to 2022, it’s fair to wonder how much more pain there is to come. For now, it seems as if the Federal Reserve remains on a very different path to investors, with a clear determination to lower inflation. Have no doubt, a combination of weakening growth and rising rates is poor for both the economy and for risk appetite. If there is a cause for optimism, then it might simply be that the Fed could be close to reaching peak hawkishness, even if capitulation looks somewhat further away. Bear markets do inevitably create opportunities, particularly for contrarians. We see a logic in focusing on capital preservation for now and remaining patient when considering adding risk.

Asset Allocation:

  • Equities: Stock market indices across the world have seen notable drawdowns year-to-date, with over half of the constituents of both the NASDAQ Composite and Russell 2000 Indices witnessing declines of at least 50% during one point last month (per Bloomberg). Despite multiple compression, many equities remain expensive relative to history. Even ‘cheap’ markets can see declines, particularly when the notion of value traps is being replaced by that of growth traps. What current market action has shown us is just how quickly the tide of passive money can recede. Our focus remains firmly on active managers with differentiated strategies. For the long-term, own a combination of growth and value, quality and cyclical.
  • Fixed Income/Credit: Bond yields are looking increasingly attractive versus equity yields, particularly in the context of the Bloomberg World Bond Index having lost $18tr in the first four months of 2022 (no data for May currently available). We see some logic to invest in US Treasuries given the combination of their year-to-date drawdown and the fact that inflation expectations may be rolling over. They would also provide a safe haven were growth to turn more negative. Other areas of the credit market remain more challenged and we note the widening of high yield credit spreads. Remain selective.
  • Gold/ commodities: We have been positive on commodities for some time and believe that adding them to portfolios should improve risk-adjusted returns. We see a case for owning a diverse basket of such assets. A backdrop of supply constraints is an additional near-term driver. Gold (and listed miners) should also benefit from their safe haven status.
  • Alternative Assets: Take advantage of still-low real interest rates to gain exposure to hard assets. We reiterate our stance of increased allocations towards this space. 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.
  • 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.
  • Currencies: With the US Dollar Index having hit a 20-year high last month, we have not been surprised to see some mean reversion over May. The Fed remains ahead of other developed world Central Bank in its pursuit of inflation via higher rates, but others (particularly the European Central Bank) are catching up. The mean reversion trade may endure.

There really is a remarkable reluctance to use with any regularity a word that has recurred repeatedly recently. That’s right- if you hadn’t guessed it – the risks of a recession are rising. Inflation has been replaced as the top concern in the minds of investors. Or, to put it another way, the current sell-off is less about the fears of rising inflation and more about the fears of its consequences, especially if not brought under control. Soft landings rarely happen. If recession becomes the base case, then such an outcome is typically unfavourable for risk assets. Much focus should now be on capital preservation.   

The sell-off of 2022 has been generally orderly to-date, even if the risk-off mood has deepened as time has gone on. Many might argue that such price action – particularly at the more speculative end of the investment spectrum – has been long overdue. It can sometimes be good to purge the market of excesses. We also shouldn’t forget that recessions are, of course, inevitable.

Given this backdrop, the logical question to consider is how much more pain is to come? From our perspective, what we’re currently seeing could be part of a sustained decline that may endure for months rather than just weeks and be felt across a full range of asset classes, industry sectors and geographies. Perhaps it’s not surprising then that investors’ cash levels are at their highest since 2001. Beyond their caution on equities (where they are the most underweight since the nadir of the pandemic in May 2020), fund managers are the most pessimistic on both global growth and systematic financial risks since 1994 (all data per Bank of America Merrill Lynch). Against this background, the ‘everything rally’ of the recent past has morphed quickly into an ‘everything sell-off.’

There is good reason for such concern. Think of it like this: the world’s two largest economies are deliberately bursting bubbles – in US financial markets and Chinese housing. There will inevitably be consequences. At the same time, regardless of these actions currently being undertaken by authorities, it is difficult fully to control either the ongoing coronavirus pandemic or the war in Ukraine. Supply chain challenges are having a very real impact on how both businesses and consumers assess risk and do their future financial planning, as was abundantly evident to your author when on a nine-day business trip to the US during May.

Weakening growth and rising rates is not a good combination for any economy. Don’t forget, we’re still in the middle of a perfect inflationary storm. The last headline print for the US was 8.3%, ahead of consensus expectations for an 8.1% increase. Food costs are rising at their fastest pace since 1981, while the Cleveland Fed’s trimmed mean measure is at its highest since 1983 and the Atlanta Fed’s ‘sticky’ measure at its most elevated since 1992. Further, with there never having been more open jobs in the US than at present, it is very difficult for employers to keep wages down. This latter point was emphasised to us with regularity on our US visit, while every person with whom we spoke also cited the rising cost of petrol as a notable concern.

At the same time that inflation is showing no notable signs of abating, global GDP estimates are coming down, not helped by ongoing pandemic-related lockdowns in China and their impact on trade dynamics. Purchasing manager index (PMI) data in China already show that the economy is in contraction, while similar PMI figures from the US and Europe chart a decline from peak levels. This often portends recession. Looking forward, it will be crucial to see how the (already-pressured) consumer copes with inflation and higher rates, especially given that consumption is the largest component of aggregate demand in developed markets. Currently high savings ratios combined with low levels of delinquencies and loan defaults provide a cushion of comfort for now.

All the above will inevitably have an impact on corporate earnings and the confidence with which businesses assess the outlook. A strong first-quarter earnings season is now firmly in the rearview mirror. Growth in Q2 and Q3 will be poor, especially given harder (more normalised, post-pandemic) comparisons relative to a year ago and the recent strength of the US Dollar. Concerns recently cited by bellwethers such as Walmart and Target may be a sign of things to come. Given the context of higher wages and other input costs, it would perhaps be logical for companies to talk margins down, even if just to clear a lowered bar later in the year.

The outlook for earnings may, of course, be largely irrelevant given not only the high starting point for current equity valuations but also the fact that the Federal Reserve is still on a very different path to investors. Put another way, the Fed seems determined to lower inflation. It seems unlikely to shift in its pursuit of tighter financial conditions until yields shift higher, stocks fall more and the housing market turns as well. Jerome Powell, the Fed Chair, appears unrepentant in his policy choice, saying that “no one should doubt the Fed’s resolve.” He is prepared to push rates into “restrictive” territory if necessary. While the Fed’s rhetoric is unambiguous, the US Central Bank may perhaps be too optimistic in assuming that the economy should “advance at a solid pace” over the remainder of this year (per its most recent Minutes). It might then not be unfair to wonder what comes first, the end of inflation or a recession? If the latter, then stagflation may be the unpalatable outcome.    

Let’s not forget, however, that recession is a convenient catch-all term (just like bear market). Each is different. Were the US/ global economy to take this path, then our sense is that it is unlikely to be as bad as 2008, even if there will be casualties. Both consumers and corporates appear in markedly better health than in the last cycle. Further, we see some clear causes for optimism: even if the Fed is far from capitulating, it may be close to peak hawkishness. Beyond the get-out clause that the US Central Bank remains “data dependent”, we note that both 5-year and 10-year inflation breakevens (the difference between nominal yields on fixed rate investments and real yields on inflation-linked investments of a similar maturity) have already fallen from their peaks. Further, while US households expect inflation to be at 6% a year from now, in three years time, they see it at ‘just’ 4%. Peak hawkishness, of course, is not the same as capitulation. For this to occur, we believe economic data would need to deteriorate markedly from current levels and/or capital (out)flows to accelerate.

Even if the current macro set up is unfavourable for risk assets, bear markets create opportunities. The negative positioning of many investors may provide fertile ground for contrarians. We shouldn’t forget, however, that it took the NASDAQ Composite Index almost a decade to return to prior peak levels after the bursting of the TMT bubble. Logic would suggest that investors should be patient when considering adding risk. Capital preservation should be top of mind currently. While the breakdown of traditional correlations has put many conventional hiding places out of risk, our counsel is to continue diversifying wherever possible.

Alex Gunz, Fund Manager, Heptagon Capital

Disclaimers 

The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital LLP believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital LLP, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. 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. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital LLP is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital LLP disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document. 

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Heptagon Capital LLP, 63 Brook Street, Mayfair, London W1K 4HS
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