View From The Top: We’re just getting started
View from the very top: we’ve just got started with 2022, but what if January’s market moves are indicative of how the remainder of the year may pan out? It does at least seem clear that the Federal Reserve is only at the beginning of its rate hiking cycle, so be prepared. Market participants have finally begun to wake up to the fact that as the flood of cash recedes, some retrenchment is going to be inevitable. US financial conditions are tightening just as economic growth is becoming softer. Don’t panic though. Intermittent market sell-offs do happen. All it may take for current risk aversion to reverse could be some slightly less bad inflation prints or more moderated Central Bank hawkishness. Even if out-of-sync economic growth rates and monetary policies across the globe do exacerbate currently volatility, they will also create opportunities. Remain nimble and be diversified.
- Equities: The 5% fall in the MSCI All-Country World Index in January constitutes the worst month for global equities since March 2020. Resets are inevitable, especially in the context of a 87% gain recorded since the Index’s March 2020 trough. We still prefer equities over bonds given that both earnings and dividend yields generally remain above comparable bond yields levels. However, be highly selective. Year-to-date, a contrarian approach has worked, owning areas of the market that were previously out of favour. Value as a style seems to be having its day in the sun. Longer-duration businesses are inevitably more sensitive to changes in interest rates. We favour a balance of styles and believe there is a case for being both tactical and opportunistic. Own China and emerging markets for the long-term.
- Fixed Income/Credit: Even if US Treasuries have seen their worst start to a year since 2009, we still think it is too early to be constructive on much of the fixed income space. Bond yields have been unnaturally low for years and despite recent upward moves, over $11tr of debt globally still offers a negative yield (per Bloomberg). Stubborn US inflation and a path to higher rates remain additional risks. Divergent Central Bank monetary policies globally will likely create some opportunities, particularly given how negative consensus appears to be positioned on the merits for credit (per the latest Bank of America Merrill Lynch investor survey). For now, stay on the sidelines.
- Alternative Assets: We reiterate our stance of increased allocations towards this space. Take advantage of below zero real interest rates to gain exposure to real assets. Collateral-backed cashflows are attractive since they can act as a clear inflation hedge. We advocate exposure to business models with strong balance sheets especially within the real estate/REIT space. Infrastructure and logistics assets constitute potential opportunities.
- Gold/ commodities: After a poor performance in 2021, gold has outperformed year-to-date in 2022. As we have noted in previous commentaries, uncertainty generally benefits this asset class. We see a logic in diversifying beyond gold into selected other commodities as an ongoing hedge against geopolitics (particularly in the Ukraine) coupled with the inflation-protection benefits these assets would bring. Listed (gold) miners also provide indirect exposure to this theme.
- Currencies: Safe haven currencies such as the Swiss Franc have benefited in the risk-off environment so far this year. Meanwhile the Dollar may continue to enjoy support from the Fed leading (relative to other Central Banks) in the hiking cycle.
2022 was always likely to be a harder year than the one prior. The ‘easy’ post-pandemic money had already been made. Year-to-date moves also need to be seen in context. The MSCI World All-Country World Index had rallied almost 100% from its March 2020 nadir through to the end of last year. This market is down just 5.5% from its all-time nominal high. If you had invested at the lows, you would still be up around 87%. Hindsight is certainly a wonderful thing: when in a bubble (per last year), no-one wants to hear the bear case. Positioning in certain areas had reached extremes. Choose your acronym: ARK, FANG, IPOs and SPACs, and let’s not forget Bitcoin too. Since the hardest-hit parts of the market are also some of the highest profile, this has made the situation feel worse than it is.
Intermittent sell-offs will, of course, always happen. Your author’s major take-away from having worked in financial markets for almost a quarter of a century is that the worst possible thing to do now would be to panic. It’s still not clear whether this is just a minor ‘correction’ or a major turning point. Maybe we’re only just getting started. Even with experience, we are still wary of trying to infer too much from the past, particularly given the unprecedented stimulus (both monetary and fiscal) that has been unleashed ever since the Great Financial Crisis, combined with the presence of persistent inflation for the first time in decades. If circumstances are truly different this time around, then previous playbooks clearly won’t work (so well). From our perspective, being diversified and being nimble are both paramount to survival.
What we do feel we have relative certainty in asserting are the following. First, it is impossible to say for how long this current period of risk aversion will endure. Tensions in the Ukraine provide another unfortunate source of uncertainty. Next, clearly lower valuation starting points for any asset would argue for superior long-term returns. Even if it is too early definitively to be advocating a buy-the-dip stance, there is a logic in starting to average-in to high conviction positions. Finally, it’s not all panic. Despite the tumult in equity markets, the high yield, asset-backed securities and commodities markets have experienced relative calm thus far. This said, historic full-blown crises have started in one area and then metastised to others. At the least, the current reset should provoke a reassessment of the case for all assets.
Have no doubt, this is a challenging environment. Financial conditions are tightening as economic growth is becoming softer. Stimulus-based expansion is over. As the flood of cash recedes, some retrenchment is inevitable. If we learned anything in the past month then it is simply that market participants have finally woken up to the fact that the Federal Reserve is going to end liquidity. Given how negative real (inflation-adjusted) yields remain, maybe we’re only just getting started. If 2020 was the year of a pandemic-inspired growth shock and 2021 was the year of an inflation shock, perhaps 2022 will be the year of a rates shock.
Jerome Powell, Chair of the Federal Reserve, now says that he is “of a mind” to raise rates in March. Just wind the clock back to end of 2020, and higher rates in 2022 seemed almost inconceivable. Economists rarely get things right, but consider that the consensus then for end-2021 inflation in the US was 2.0%. December’s reading was 7.0%, with the 2021 full-year print at 5.3%. Such a dynamic inevitably implies a massive change in Central Bank positioning. Forecasters may also be too optimistic in assuming that base effects will result in US inflation dropping back to 2.6% by the end of this year. From what we see, it looks increasingly entrenched. Underlying inflation (as defined by the New York Fed) is at its highest since 1995, while the ‘trimmed mean’ metric (favoured by the Cleveland Fed) is at levels last seen in 1991. Annual wage growth in the US stood at 4.7% in December, the sixth consecutive month this reading has come in at over 4.0%. The metric never exceeded 3.5% in the 10 years prior to 2019. Like it or not, consumers will be factoring these trends into their current behaviour much more so than any opinions about where inflation may end up at the close of the year.
Investors are sometimes prone to failing to distinguish between the stock market and the real economy. Forget about the ‘Fed put’ for now. The US Central Bank certainly does not look as if it is going to give up fighting inflation, especially given how stubborn it currently is. From an investor’s perspective, it’s certainly easier to make valuation (i.e. buy-the-dip) arguments when inflation is stable rather than volatile and rising. To expect positive returns from (US) equities when the Fed may hike up to five times, at the same time that it is shrinking its balance sheet, may be just too optimistic. As we’ve noted previously, this is a very different cycle. Corporate profit margins are already at record levels and consensus earnings estimates call for a marked slowdown in earnings growth in 2022, off a high 2021 base. We are not debating that US interest rates should rise, particularly given where inflation, unemployment and real yields stand. However, it’s still very unclear at what levels – in this cycle – higher rates become restrictive to economic activity. For now higher rates look unlikely to cause an economic recession, even if they can clearly invoke further dislocation in financial markets.
Importantly, there’s always an alternative view to consider. It’s amazing how quickly sentiment can change: bearishness has become the default. Many market participants seem to have ‘bought’ the narrative that the Federal Reserve is behind the curve and that it needs to tighten. The corresponding price action, the implied number of rate hikes discounted (see Bloomberg’s WIRP function) and the shape of the yield curve imply that the market is already doing part of the Fed’s job and has de facto started to implement tighter financial conditions.
Against this background, all it may take is some relatively less hawkish commentary from the Federal Reserve and/or some less bad inflation data. A weaker macro backdrop may also see the US Central Bank dialling back its hawkishness. Global economic growth is slowing. The IMF cuts its forecast for 2022 world GDP growth in January to 4.5% relative to 4.9% a quarter prior. The main reason for doing so was the ongoing coronavirus pandemic. While life in your author’s home country (the UK) has now gone broadly back to normal, elsewhere, COVID remains a concern. The pandemic is certainly not over, just reinventing itself. Beyond the macro, remember also that a strong corporate earnings season (only a third of the S&P 500’s constituents have reported to-date) could also help improve near-term investor sentiment.
As a final observation, lest readers feel that this commentary has been too US-centric, it is worth considering the very different direction of travel currently for other global Central Banks. The Bank of Japan has said that “raising rates is unthinkable” while the ECB believes there is “every reason not to raise rates quickly.” China has gone the opposite way, with the PBOC loosening policy, which partly helps explain why the Chinese stock market is outperforming on a relative basis year-to-date. Nonetheless, the ongonig reinvention of the pandemic (in different forms, in different geographies) implies an uneven global economic recovery, while out-of-sync Central Banks across the world probably only increases volatility. That said, one person’s volatility is another’s opportunity. Stay nimble and diversified.
Alex Gunz, Fund Manager, Heptagon Capital
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