Commentary: Optimism fades as inflation remains uncomfortably high

February did little to reduce the uncertainty around growth, inflation and policy settings. Inflation remained uncomfortably high in most regions, economic growth ambiguous (enough for both the bulls and the bears) and central banks continued to lift rates and gave little confidence that the peak is in sight. Sovereign yields moved higher, equity prices lower and the USD firmed. 2023 will be another challenging year.

Our view has been the broad based rally in equity markets since late September was a bear market rally and unlikely to be sustained, so the petering out of this rally in February was no surprise. Valuations had become expensive again (particularly relative to the inflation backdrop and in the key US market), inflation was persisting at uncomfortable levels giving central banks no reason to moderate their hawkishness. In effect, the optimism that had fuelled the rally was dashed. We began taking profits on our equity allocation in January and accelerated this risk reduction through February.

A tale of two scenarios

We find it difficult to articulate a plausible ‘bullish’ scenario for equities from here. Instead, we see one of two scenarios unfolding.

The first, that the economic cycle takes longer to play out than markets currently expect. This extended slowdown reflects the variable and extended transmission of higher rates into key economies (particularly in the US, given the high percentage of 30-year fixed rate mortgages) and against this, inflation stays uncomfortably high, and as a consequence, so do interest rates. In this context earnings will continue to moderate and equity multiples de-rate to align with the stubbornly high inflation regime. In the US, for example, we see price earnings (PE) multiples at around 19-20 times as expensive for this environment.

The second is a more rapid descent into recession (our recession models all flag this as a high probability) as accumulated household savings reverse and as higher borrowing costs start to impact. This may be a second half of 2023 story. Profits could fall rapidly and while recession will alleviate demand pressures and help inflation fall, this won’t offset the impact of weaker earnings. A typical ‘cyclical’ recession could see overall earnings decline by around 15% in the US. Current market expectations are for flat earnings for 2023 in the US.

Looking forward, our returns continue to favour Australia and Japan and emerging market equities. The US is our least preferred market, given it remains the most expensive on an index basis, albeit recognising that this still reflects extended multiples in a few key large stocks.

The weakness in sovereign bond markets over the month reflects the inflation stickiness at uncomfortably high levels and a growing realisation that the peak in rates may still be some way off, and that rate cuts are  off the table in the foreseeable future.

To peak, or not to peak?

While there’s growing evidence that inflation globally is peaking, it’s far less clear and more important to both policy makers and markets what its trajectory from here is and where it settles. A moderation in the inflation rate due to lower energy prices and easing supply chain pressures does not equal disinflation, particularly with labour markets globally still tight. We do not expect a neat and linear return to the policy environment that prevailed pre-COVID and we think the market will be surprised by inflation stickiness (both in terms of the rate of inflation and the time it takes to revert to a sufficiently low level).

For sovereign bonds, we think the year ahead will be characterised by volatility around the current trend as competing pressures of sticky inflation, moderating growth and hawkish central banks play out. We think the Fed will remain hawkish, given the reduced sensitivity of the US economy to rate rises (due to the dominance of longer dated, fixed rate mortgages). In Australia, notwithstanding the growing political pressure on the RBA, and the higher sensitivity to shorter dated fixed rate and variable borrowing, the RBA will also need to do more tightening to create the spare capacity needed to relieve domestic demand pressure.

We are around ‘neutral’ from a duration perspective, but do expect continued volatility in sovereign yields and opportunities to adjust duration (up and down) will result. There are opportunities in yield curves. Specifically, we think the relatively steep Australian curve will likely flatten as the RBA looks to get on top of inflation, while in the US, the inverted US curve could steepen as the reality of sticky inflation drags longer dated yields higher.

The attraction of credit

We do believe credit is good middle ground and offering a number of opportunities.

One of credit’s most attractive attributes is its diversity and presents a range of opportunities for both carry (high quality investment grade credit) and higher returns (securitised/asset backed securities). We are more negative in the high yield credit space where credit spreads have narrowed appreciably since September and the risks look more aligned to equities.

Our constructive view on investment grade credit comes from both the relative stickiness of credit spreads, combined with higher yields underpinned by higher sovereign yields across the curve. While we expect volatility in both credit spreads and yields, overall compensation for risk is reasonable and the premium above cash meaningful, suggesting holding in portfolios for carry. We also like securitised credit and have been switching from Asian corporates (which have performed strongly since China reversed its COVID policy) into US securitised. This is more opportunistic in nature and derives from a liquidity void in this space as banks have stepped away to focus on their balance sheets, pushing spreads wider.

We continue to see good opportunities in private debt. In the direct corporate lending space, both higher yields (given the floating rate nature of lending) and wider risk premia (given economic uncertainty off the back of higher rates) have pushed yields for new lending into the low teens. Likewise, in the direct commercial real estate lending market both yields and risk premia remain attractive for secured lending with solid loan to valuation ratios providing protection.

Fine-tuning in February

We have been active in the portfolio in February, reducing equities by a further 5% (following a -7.5% reduction in January), we also cut our tactical global high yield credit exposure from 3% to 0%, reduced our emerging market corporate debt allocation by 1% and added 5% of our credit exposure into securitised credit. We also added back 1.5% to the US dollar exposure against Korean won and Taiwan dollar and added 0.25 years duration as yields rose.

Overall our position is very defensive with 17.5% in equities, 30% in cash and sovereign bonds and credit positioning skewed heavily towards the lower risk segments of investment grade corporates at 21% and securitised assets at 5%. Our diversifying assets have been reduced to 26.5%, and are mostly Australian higher yielding securities, emerging market debt and insurance linked securities.

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