multi-asset
Hard or soft landing? Macro adaptation in multi asset
Is the worst over? Some investors remain unconvinced, while others are animated by animal spirits as macro data and policy action stoke expectations that markets can rise from the ashes of 2022.
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Need to know
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Eyes on the road…
Markets, taking a forward-looking view, will happily leave 2022 in the rear-view mirror. The normalisation of real rates and aggressive central-bank tightening drove the biggest fixed income sell-off in 70 years and global stock markets suffered their worst annual falls since the Global Financial Crisis.
But China’s reopening, easing US inflation and Europe’s mild winter spurred a relief-rally in January. This month, the US and European central banks continued to hike interest rates – by 25 basis points and 50bps respectively – but their shift from aggressive to moderate hawkishness gave the rally more oxygen.
With the Federal Reserve (Fed) only nearing its expected terminal rate – although this may rise given the strong job market – and the European Central Bank (ECB) curtailing its forward guidance by committing to one more 50bps increase before taking stock, markets have largely absorbed the implications of this phenomenal tightening cycle. Investors are watching keenly as rate-setters try to extinguish inflation amid robust employment, but they are also looking forward, asking: how will the economy land?
If rates were the key macro force last year, growth is in the driving seat in 2023.
…Hand upon the wheel
Growth, inflation and real rates are three macro forces with proven explanatory power over market returns. Figure 1 shows how they have influenced US equities in the past two decades, and provides two key insights for investors this year:
- Throughout 2007 and into 2008, real rates progressively became the main factor underpinning returns, as Fed hiking continued until the US subprime-mortgage market collapsed. From February 2008, growth drove returns, explaining why asset prices declined as economic and market conditions deteriorated
- Today’s situation is similar. As we know, real rates were a powerful driver of returns last year, but as in early 2008, signs of recession are everywhere. For investors, trying to gauge the severity of the slowdown is important, bringing growth into focus
FIG 1. Explanatory power of growth, inflation and real rates on US equity returns
Source: LOIM, Bloomberg. For illustrative purposes only. Please note: this analysis uses the US as a proxy for global markets and macro data, drawing on S&P 500 returns, US growth and inflation surprise indices, and changes in US 10-year real rates.
Touching down
The global economy has been in recession for four months now. Our proprietary nowcasting indicators – which provide real-time data on global growth, inflation and monetary policy – show that the current downturn began on 19 October. The US and Chinese economies started contracting earlier in the month, while Europe fared better, primarily because ECB tightening had not begun in earnest and the winter heating season, in a time of high energy prices, had not started.
Fast forward to February, and the global economy remains in recession territory. But in an encouraging sign, 60% of Chinese economic data are improving and Europe’s resilience continues, according to our indicator. Inflation has eased further, especially in China and Europe, and monetary policies show signs of moderation. Positive GDP revisions offer comfort, too: since June 2021, estimates of output have been consistently revised upwards as pandemic-era stimuli continue to enable spending despite recessionary conditions.
FIG 2. A smooth descent?
Source: LOIM at 3 February 2023. Please note: LOIM’s nowcasters gather economic indicators in a point-in-time manner to measure the likelihood of growth, inflation and monetary policy risks. The nowcasters vary between 0% (low growth, low risk of inflation surprises and dovish monetary policy) and 100% (high growth, high risk of inflation surprises and hawkish monetary policy).
Landing: hard or soft?
Week by week, the case for a soft landing builds. Or does it?
The International Monetary Fund has lifted its forecast for the global economy, judging it will grow by 2.9% this year, with all major economies except the UK avoiding recession. Speaking after the Fed’s recent downshift, Chairman Powell allowed that “inflation has eased somewhat” but reiterated that it remains in the central bank’s crosshairs.
But on the same day, Purchasing Managers Index data showed the US manufacturing sector had contracted for a third consecutive month to a level consistent with recession in the broader economy. Later that week, surprisingly strong US job numbers were published, in which non-farm payrolls increased by 517,000 against expectations of 188,000. Will this compel hawks at the Fed to argue for more forceful action at its next meeting?
Or can the Fed and ECB achieve a groundbreaking result, and talk the global economy into a soft landing? In a departure from fighting inflation principally by hiking rates until they cause enough unemployment to suppress wages, the central banks are apparently trying to keep their policies tight enough for real rates to track the potential growth of the US and European economies. By doing this – and choosing their words carefully – they seem to be attempting to create an expectation in the market: that inflation can be controlled while maintaining unemployment at a level that does not cause wages, and therefore inflationary pressures, to rise. Can it work? The concept of self-fulfilling prophecies is an old – and powerful – one in economic theory.
All of these developments create a complex growth scenario that multi-asset investors are trying to understand.
Our positioning: ready and wary
In our All Roads range of multi-asset strategies, we are positioned for a soft landing but are hard-landing wary. Our nowcasters aim to assess the sensitivity of risk premia to changes in the economic cycle, underpinning our Macro Risk Premia (MRP) overlay, one of the dynamic tools we use to change the tactical positioning of our portfolios. Based on macro data rather than price signals in the market, the MRP overlay provides diversification from our trend-following and bond and commodity carry strategies. Altogether, these overlays inform our marginal overweight to equities and credit in our dynamic asset allocation. We are constructive, not bullish, and ready to react if turbulence disrupts the soft-landing narrative.
The old normal: higher-for-longer rates
Growth is poised to be the key macro diver for market returns in 2023, but let’s not forget the regime change already well underway: stimulus, savings and the green transition mean that elevated real rates are here to stay.
Deeper deficits, incurred by stimulus, are still supporting prices and therefore exerting a long-term inflationary effect. Friction and structural change in supply chains following the pandemic – as deglobalisation and protectionism feature more prominently in industrial policy – are also driving up input costs for businesses, further underpinning price increases (see figure 3).
But with economies slowing, consumers are drawing on accrued savings. This has assisted the soft-landing cause by sustaining consumption, but history shows that such deployment of savings into the economy contributes to a spike in real rates (see figure 4).
Beyond the consumer, the environmental transition requires immense investment by governments and businesses of approximately USD 5.5 trillion annually to 2030. This stands to further increase deficits and drain savings, especially as strong demand will increase the cost of materials and skills needed to green the economy (see figure 5).
As consumers spend today and investments are committed to the economy of tomorrow, the structural support for higher real rates gets stronger.
FIG 3. Expected inflation as a function of increased deficits
Source: LOIM, Bloomberg as at September 2022.
FIG 4. US real rates vs savings as a ratio to GDP
Source: LOIM, Bloomberg as at January 2023.
FIG 5. Greening the economy will drain savings and drive real rates higher
Source: LOIM, Bloomberg as at January 2023.
Ready for the next decade
As we have described previously, the rigid capital-allocation practices of many traditional multi-asset strategies, like the 60/40 portfolio, tend to conceal concentration risk and lead to a false sense of diversification. Because many were not truly diversified and placed a lot of their eggs in the bonds basket, they did not benefit from the resurgence of commodities in the past two years.
A scenario with higher-for-longer real rates is therefore likely to weigh on the performance prospects of 60/40 portfolios. In contrast to the years of the Great Moderation, tomorrow’s diversifier could come from outside the fixed-income world. Risk-based multi-asset solutions, which seek consistent diversification among risk premia instead of following capital-allocation policies, are built to continuously search for the next diversifier.
This diversifier could be bonds or commodities, or manifest as volatility strategies. Whatever it is, a well-executed risk-based strategy should identify and harness this source of return. Figures 6 and 7 illustrate how a risk-based strategy can achieve its objectives during periods with low rates and adapt to environments in which they rise forcefully, such as the 1970s.
Instead of being constructed to suit a given scenario, risk-based solutions are built to adapt to the uncertainty that typifies markets. Our All Roads range aims to deliver this for investors with diverse risk appetites and portfolio requirements – including as a complementary and liquid source of growth or diversification alongside traditional multi-asset strategies.
FIG 6. What happens when real rates rise…?
Source: LOIM, Bloomberg. For illustrative purposes only. Past performance is not a guarantee of future results.
FIG 7.…Risk-based solutions can prove their ability to adapt
Source: LOIM, Bloomberg. For illustrative purposes only. Past performance is not a guarantee of future results.
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