multi-asset
Multi asset: what do macro and market signals tell us?
We may be in a late phase of the economic cycle and the investment backdrop remains in flux. As many children globally head ‘back-to-school’ in September, our multi-asset team drills into what the data mean and which asset classes are showing more positive signals.
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US growth and inflation surprises
A recession has been expected since the start of the year, but the data still fail to indicate it. Worse, our nowcasting indicators are currently showing growth picking up, especially in the US. While the vast majority of the economic data were declining three months ago, since the start of August, the message from our indicator has been very different: currently 65% of the data we collect is improving in the US.
Can we have a recovery without a recession? It’s a tough question, but one that needs answering to sail the complex waters of 2023. As such, the inflation question is back. There too, our inflation surprise indicators have started capturing a shift since May, showing a persistent signal of inflationary pressures building. Whether due to rising commodity prices over the quarter or to still-elevated wage growth, a wealth of indicators are continuously being pressured higher. This does not stop the long-term journey towards disinflation, but the road there could be bumpier than expected.
Figure 1. Global growth and inflation Diffusion Index (DI): percentage of increasing macro data within a month
Source: Bloomberg, LOIM. For illustrative purposes only. As of August 2023.
Policy outlook clearer
The area where we see the least surprise potential is monetary policy. In line with Federal Reserve (Fed) chairman Jerome Powell’s speech at the Jackson Hole meeting, inflation remains an issue that the Fed and other central banks are ready to tackle with only minor rate adjustments, in light of the policy already deployed.
The message from our indicators is crystal clear: the least surprising aspect of the macro picture is monetary policy. A couple (literally) more hikes maybe, but most of the game now consists of keeping rates as high as they are now for a long enough period of time. How long? It’s tough to say, but it’s also not necessarily the most important issue when it comes to investing, in our opinion.
Assessing the phase of the cycle
The essential question for markets is: which phase of the cycle are we in? The answer appears probably too easy: in a classic late cycle phase. Still high(er) inflation, persistent growth and high rates are the three key markers of that phase.
What happens during such periods? Usually, commodities outperform other asset classes. We have seen the burgeoning of higher raw material prices since May and there are reasons to believe that this could persist. Higher commodities could help support equities and, more importantly, emerging-market (EM) equities. With the Fed having delivered most of its policy tightening – 10-year real rates are anchored around 1.9% currently, which is more than enough – the dollar could stabilise if not weaken. Alongside this currency shift, EM assets could look attractive again, especially given their current valuations. The progression of commodities and EM assets means duration risk should continue to look unattractive and remains the foremost investment risk we perceive.
If this is a late cycle period, we should remember what to do in such circumstances – invest in reflation and in higher beta assets, without forgetting how temporary such phases can be. And the next step is more likely to be a recession than an expansion, so let’s keep our finger on the trigger and be ready to buy bonds again. Just not now.
Reviewing the signals
As systematic investors we avoid taking big bold bets, being more concerned about covering all bases rather than betting on one correct scenario. Thus, we prefer to prepare rather than forecast and follow a disciplined, process-driven, risk-based investment approach.
Our process integrates a number of signals, which are interesting to review. At this point in time, and contrary to earlier this year, our signals are pretty consistent with one another, whether they are informed by price dynamics or fundamental macro data. Sovereign bond valuations are undoubtedly more attractive than, say, one or two years ago, although yield curves are inverted, which nullifies one of the traditional positives of bond investing. Furthermore, bond volatility remains at extreme levels (figure 2), reflecting a high degree of uncertainty about macro factors that drive bond returns, namely growth and inflation prospects. Finally, price dynamics are negative across all the main markets (US, Europe and Japan), bar China.
Thus, while bonds should prove useful if or when a recession does indeed materialise, they are not a glaring buy at this point, in our view.
Figure 2. Put volatility estimates
Source: Bloomberg, LOIM estimates. As of 25 August 2023. For illustrative purposes only.
What shows promise?
Other asset classes display more promising signals. Credit spreads, equities and commodities have all seen their volatility normalise over the last few months, moving back to their long-term normal levels. Price dynamics are more positive, too, with broadly positive signals across regions, although Europe has started to soften in the last few weeks, while China continues to be weak and drags the MSCI EM index in its wake. After a volatile first half of the year, commodities benefit from a strong momentum, too. We believe that all of these merit continued investment, and we currently run above-average allocations. Finally, risk management remains essential, in our view.
Today, as the environment is persistently challenging, our positioning remains prudent, falling back on that simple shock absorber, cash (where we are overweight compared to our historical norm), to fine-tune our risk deployment and remain in line with, but not exceed, our portfolios’ and our clients’ risk profiles.
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