Commentary: Tighter policy squeezes debtors, but benefits asset rich

The conundrum continues. After the fastest monetary policy tightening cycle in generations, central banks remain ‘in-play’ and ready to tighten further. The global economy is more resilient than generally expected, particularly the US economy, and has so far weathered the storm of higher interest rates. There are a number of theories being bandied about to explain the surprising resilience, from households drawing down COVID-related savings buffers to spendthrift Boomers breaking the shackles after years of very low interest rates, spending their higher investment income on services. For central banks, the reason doesn’t matter. The risk for them remains that demand for services (which is 80% of the US economy, for example) keeps the labour market very tight and maintains pressure for real wage gains (wage increases that more than compensate for higher inflation). Without productivity gains, this shifts inflation from a transitory problem to a more permanent one. Central banks will likely fail on their primary objective if higher inflation expectations become embedded in business and consumer behaviour.

Twin problems

In our opinion, the problem for central banks is twofold. Firstly, they really have only one tool and it’s a very blunt tool to fight inflation – increasing official interest rates to seek a reduction in aggregate demand and to increase unemployment. As the BIS warned last year, aggressively tighter monetary policy has a second order effect by worsening inequality. By pushing debtors into serious financial trouble, but helping those with substantial financial assets (an increasingly large demographic thanks to Boomers retiring with pensions) who do relatively well and keep the economy humming, the wealth gulf widens even further. This could mean monetary policy has lost some of its potency – feeding the ‘have’s’ while starving the ‘have-not’s’ - and financial conditions are not yet tight enough to impact aggregate demand.

Secondly, by focusing on the labour force, particularly wage increases and productivity, and targeting a higher unemployment rate, central bankers are watching the rear-view mirror to set policy as the unemployment rate is a lagging economic indicator. In this down cycle the labour market could remain even more durable than typical and lag the economy even further than usual, as businesses, recently caught-out by labour shortages post COVID, hoard their workforce and only retrench workers as the last resort. This prolongs the cycle as the impact of monetary policy is diluted and the risk of a policy mistake substantially increases as central banks overtighten and tip the economy into recession. Central bankers are acutely aware of the risks of overtightening but have stated consistently they will err on the side of caution regarding inflation, as this is the greater long term economic problem. Engineering a soft landing is incredibly difficult with such a blunt policy tool. This is why we believe the probability is higher for recession than for a soft landing.

Back to defensiveness

Just as central bankers don’t know the tipping point for official interest rates, investors don’t know either. However as investors, we can monitor the economic indicators that typically lead the business cycle and we can adjust our portfolio positioning as market pricing of bond yields and equity valuations shift from being overly pessimistic to overly optimistic. In September last year, our assessment was market pricing was overly pessimistic for the outlook. We substantially increased the risk level of the portfolio by doubling the equity exposure and increasing credit exposure. As equity and credit markets recovered, valuations become more stretched for our assessment of the risks to the economy, particularly as central banks remain an active headwind and biased to higher rates. As a result, from March this year we have shifted the portfolio back to be more defensively positioned, reducing equities, hedging exposure to non-investment grade credit and increasing the portfolio’s risk hedges (duration and foreign currency exposure) which should do well as the economy slows. We have maintained a high exposure to investment grade credit as valuations in this sector reflect the risk of recession and provide valuable income above the cash rate.

Since March, the US equity market has performed surprisingly well for the cyclical outlook, with June being particularly strong and participation broadening beyond technology. We view this move as mostly a positioning adjustment as investors (including us) were positioned underweight following the regional banking crisis. The move has been supported by company earnings growth generally beating bleak expectations, but we have observed that higher selling prices have offset falling volumes. With inflation peaking, companies will find it more difficult to increase selling prices to maintain earnings growth. With further interest rate increases in the offering and leading indicators continuing to point to recession, we expect companies to see margins compress and earnings decline in the second half of the year and with US PE’s at 21 times (17 times not including the ‘Mega Seven’) the market is not priced for our outlook. We have therefore maintained the portfolio’s equity weight at 15%. We have adjusted our credit exposure by reducing the hedge on non-investment grade issuers by 4% to reduce the negative impact of the hedge on the portfolio’s yield. In rates we increased duration exposure to 3 years by adding more Australian duration and have started shifting this exposure towards shorter-dated maturities as early signs of overtightening are starting to appear in the Australian economy. In summary, despite recent market moves in risk assets, we remain positioned for a weakening growth environment and favour bonds over equities.

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