multi-asset
No central bank pivoting: time to be cautious
In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we take stock of the Federal Reserve’s determination to bring inflation under control at the cost of economic growth and outline how this is impacting our portfolio positioning.
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An historic turn for the Federal Reserve
The Jackson Hole closing speech saw history being written. Federal Reserve (Fed) Chairman Jerome Powell emphasised that his “remarks will be shorter, [his] focus narrower, and [his] message more direct” than usual.
Throughout the speech, the determination of the FOMC to end the wave of inflation was made crystal clear: “The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2% goal.” This will happen at the expense of the economy itself: “Reducing inflation is likely to require a sustained period of below-trend growth.” The Fed’s mandate now appears clear to all investors: the cost of capital needs to progress to bring inflation down. This is an about turn of the “whatever it takes” approach when expectations sought the first sign of a pivot; this time the Fed has not flinched.
This stance dissipates a source of uncertainty – will inflation retreat? – while creating another major risk: that of a stronger than anticipated slowdown, if not a fully-fledged recession. Figure 1 shows the historical evolution of the three largest macro risks to long-only portfolios: recession, inflation and hawkish central banks, as measured by our nowcasting indicators. This usually follows the sequence: inflation risk emerging first, monetary policy then turning extremely hawkish before a recession is triggered. Today, the message is as follows:
- The peak for worldwide inflation is likely behind us
- Central bank risk is clearly higher
- Recession risk has not yet started to materialise significantly at a world level
FIG 1. Probability of key macro risks since 2001, measured by our growth, inflation and monetary policy nowcasters
Source: Bloomberg, LOIM.
A time for caution
We currently seem to be between two risks – central bank risk and the risk of recession. This in-between situation, for investment managers, is a time for caution to resonate across all of our investment lines. Please click on the tabs below to read how we are reacting across asset classes.
From constructive to conservative
We held a constructive stance towards high yield during the early months of this year. This was to access the lower duration and higher carry of this segment compared to investment grade and developed market sovereigns, at a time when corporate fundamentals and the macro backdrop were robust and supportive, even though the monetary policy cycle seemed to be turning.
Indeed, the escalation of inflationary conditions prompted central banks to tighten financial conditions aggressively and by more than market expectations. This triggered an unprecedented sell-off in fixed income generally but saw high yield outperform investment grade on a relative basis.
Towards mid-year we altered our positioning as we believed the market had repriced risk and had shifted to forward-looking risk-return dynamics. Consequently, our preference moved up the quality spectrum towards the crossover (rated BBB to BB) and investment grade segments, reducing our exposure to the riskiest part of credit (ie single-B and below).
At this juncture, while we continue to believe that corporate fundamentals are resilient and that high yield appears attractive from an outright value perspective, we prefer to take a more conservative approach. We see increasing tail risks in this late cycle environment, as central banks seem determined to tip economies into recession to fight inflationary pressures, despite the looming energy crisis.
Quality, real rates and the Next Decade
In the early part of 2022 (Q1), equity investors became worried about the yield curve flattening (USD 10y-2y) and its potential inversion. Traditionally, such a shift reflects the transition from an economic expansion phase to a slowdown and potential recession. Such a move is relevant for equity positioning as it marks a shift in preference from growth companies (especially unfunded ones) to quality companies with strong financials (capital efficiency, free cash flow, low dependency to capital markets’ funding) and solid economic moats.
Already at the heart of our investment process, such a focus on quality companies has been further accentuated so that all of our equity strategies exhibit strong financial characteristics. Interestingly, quarterly earnings reported by listed companies have remained resilient and have contributed to expectations remaining solid in terms of earnings-per-share growth (+10% in 2022e and +6% in 2023e), and also in terms of operating margins, which are at their highest level for 30 years, according to our research.
The extent to which this on-going tightening cycle in the US will materially affect these expectations remains unclear. However, we would argue that equity valuations have already anticipated some deterioration and the potential impact of a recession on earnings. Indeed, in the context of deeply negative real term rates, a rapid price / earnings normalisation towards historical averages would create an attractive valuation backdrop in our view.
We believe that only a shift from negative to positive real rates might trigger a deterioration in this attractive valuation backdrop. Based on our analysis of historical business cycles, a more risk-on positioning within equities will only be warranted when a recession reaches its midpoint and sentiment improves on the expectation of central bank pivoting. The Jackson Hole closing speech made clear that such pivoting will not be around the corner.
Across our equity strategies, we are therefore currently overweight quality companies with an ability to capture secular growth and limited sensitivity to economic cycles. Additionally, as outlined in our The Next Decade chronicles, costs relating to the use and preservation of the environment need to be internalised, making a case for strategies that focus on renewables, energy efficiency, climate adaptation, biomaterials, smart agriculture, resource efficiency, recycling, zero waste and new dietary requirements. The high level of inequality – stemming from a period of asymmetric capitalism and demographic transition – is also driving a need to digitalise our healthcare systems for efficiency reasons, while increasingly digitalised consumers will also become more open to sustainable lifestyles. These are key trends for agile brands with pricing power.
A US preference for asymmetry
We came into 2022 in a defensive position – based on our relatively bearish view of equities and credit given the macro backdrop of slowing growth and a looming liquidity withdrawal across all the major economies. We also avoided exposure to unprofitable high growth names and Chinese real estate.
Looking into H2 and into 2023, we continue to be defensive as we expect equity markets to remain volatile with little upside from here given valuations and the recent rally. In credit, we do not expect to see a significant pick-up in defaults because the redemption schedule up to 2025 is light. There could be opportunities and we are focusing on the best quality credit (BB or above). Valuations could continue to improve from here as we have seen some dislocation from the fixed income market and both rates and credit have retraced most of the recent rally.
As we look ahead, we prefer the US to Europe, because the region is less energy dependent and more advanced in its tightening cycle. In the US, we are focusing on themes that, in our view, should display an asymmetric performance to various macro scenarios: cybersecurity and quality companies with pricing power in the luxury and software sectors.
In Europe, the weak euro should support companies with a global footprint which should be more resilient in a downturn. Slowing growth, periodic Covid lockdowns and uncertainty around changing regulations and expectations for the property sector make investing in China complex, despite compelling equity market valuations. We are positioned in names where we see growth (selected consumer cyclicals, technology and reopening exposure such as airlines) and also in companies and themes which are aligned to government policy such as the green transition, which includes electric vehicle manufacturers. We have strategically avoided the real estate sector, which has paid-off this year – we do not see any reason to step back in at this stage.
A rules-based process to guide risk
We are moving from one exceptional situation to another this year. After de-risking the portfolio massively earlier this year (we had a 60%+ cash weighting in our balanced portfolio at one point, a historic high alongside 2020), we found ourselves in another unusual situation by mid-August: a very high-risk budget and sky-high volatility. Coupled with weak momentum and neutral risk appetite signals, our total exposure only increased moderately over the summer.
Nonetheless we were at around 90% by mid-August and started reducing risk again and increasing cash holdings – we currently have a 25% cash allocation. This increase in risk budget was purely driven by the opportunity cost of being disinvested and thus not participating in the rally at that time. In other words, this was purely sentiment driven.
Market-implied risk appetite measures had shot up but are now retreating. And our recent statistical study also supports that view. In addition, this summer’s rally effectively implied a divergence between the read from bond markets (“a Fed pivot is forthcoming”) to that from equities (“the Fed will successfully engineer a soft landing”); such conflicting views on the economy will need to be resolved one way or another.
Hence, we will only become more positive on the outlook into Q3 / Q4 when we have more visibility on the macro / monetary policy side. Jackson Hole provided early guidance regarding where this may go.
To summarise, we are staying true to our rules-based process for managing our portfolios. This dictated our re-risking over the summer (our upside participation in July more than made up for June’s loss) but we are far from wedded to this and have started reducing risk as dictated by our signals. If anything, we expect this has further to go.
| Simply put, with the Fed forcefully focusing on inflation, we see a reason for caution across asset classes which is reflected in our positioning. |
Macro/Nowcasting Corner
The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.
Our nowcasting indicators currently point to:
- Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum while the most recent data shows that this deterioration has room to go
- Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US
- Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected
World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)
World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)
World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)
Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).
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