Commentary: To pivot, or not to pivot? That was the question.
We still don’t know for sure whether the rally in equity and credit markets through July and mid-August was a ‘bear-market-rally’, but we do know that Jerome Powell’s hawkish rhetoric at the Jackson Hole Symposium stopped the rally in its tracks. While we know there can be a material gulf between what central bankers say, and what they do, at least for the time being the Fed’s rhetoric seems to align with the reality.
We still don’t know for sure whether the rally in equity and credit markets through July and mid-August was a ‘bear-market-rally’, but we do know that Jerome Powell’s hawkish rhetoric at the Jackson Hole Symposium stopped the rally in its tracks. This was consistent with our long-argued perspective that inflation (when it emerged) would shift the policy reaction function of central bankers and result in a fundamental shift in the policy playbook. While we know there can be a material gulf between what central bankers say, and what they do, at least for the time being the Fed’s rhetoric seems to align with this reality.
Since the GFC, and in the absence of inflation (at least at the CPI level), central bankers have responded to any sign of economic weakness or outsized volatility by easing policy in its various guises (rate cuts and quantitative easing) often rapidly and significantly, but with a reluctance to claw it back. Over this period, it’s been the right call to back the ‘Fed put’ even if fundamentals (like valuations) argued against it. For anyone whose tenure in markets is less than 15 years or so, this is the reality of your market experience. If that’s been your investment framework, then it’s been a rewarding one – until recently.
No pain, no gain
It’s necessary though to put this period into a broader historical context as it represents a relatively small sub-period of the overall economic, policy and market experience and was clearly defined by a unique set of characteristics. It would be naïve to assume that this could be extrapolated irrespective of the economic and market environment – as would any period with similarly unique characteristics. The argument leading into Jackson Hole was that the Fed should pivot, given weakness in risk assets and evidence of slowing growth, reflecting the highly asymmetric central bank reaction function of the post GFC era, and gloss over the realities of the current inflation problem. Jerome Powell challenged this thinking, articulating in his speech that inflation was the priority, that reducing it would require interest rates to rise further, growth would slow, and economic pain would ensue. Importantly though, he noted that the cost of not acting to restore price stability would be worse. If the Fed indeed follows through with this rhetoric, we will likely see more economic pain in the short run, but it will ultimately result in a much healthier and sustainable longer run environment for investors.
The unfortunate reality, though, is that we remain in the transition phase with markets yet to fully reflect the new world order. This was reflected in markets across the board in late August with a return to the tough world of rising bond yields (and falling bond prices), wider credit spreads and falling equity markets. Like the first few months of the year there really were few places to hide. How long this transition phase takes and how much more repricing occurs is always difficult to judge. Our base case though is that there is more adjustment to come.
Further tightening expected
A more granular perspective shows that macro indicators continue to soften with many consistent with economic contraction. The US has entered a technical recession after two quarters of negative real GDP and composite PMIs have dropped below 50 in the US and Europe. While there is evidence that headline inflation in the US is peaking (supported by the moderation in oil prices) it is less clear when it comes to core inflation. The US Federal Reserve increased official rates by 75bps in late July (to 2.5%, a level it sees as neutral) but, as we’ve outlined above, we expect further tightening and the relatively hawkish Fed stance to remain until they are confident that US core inflation is tracking back towards its medium-term targets. Given the gap between current inflation and target, this will likely require both weaker labour markets and clear evidence of a moderation in the trend in core inflation.
While profits (ex-energy) have started to moderate, we expect further weakness in company margins (reflecting higher input costs including wages and weaker demand) will lead to earnings downgrades. This will start to impact more significantly in September quarter outcomes but more likely in the December quarter, given the lags between policy, demand, and profits. A ratcheting down of earnings and an affirmation of more hawkish central banks will likely lead to the next de-rating lower in equity markets.
Equity exposure trending lower
From a valuation standpoint, while multiples have moderated, they remain in most cases well above levels consistent with both elevated inflation and the expected profit outcomes. Typically bear markets in US equities (for example) end with multiples in the low to mid-teens. Current multiples in the high teens are well above this. We prefer value to growth from a style perspective. While our medium-term return forecasts favour Australia, Japan and emerging markets, the broader trend will remain down. Overall equity exposure reflects this thinking with exposure at 18% - towards the lower end of our range.
This theme extends to credit with corporate earnings a key risk. Most fundamental metrics like Net Debt to EBITDA and Interest Coverage are likely to come under pressure as earnings roll over, especially for those who have to refinance at significantly higher rates (although many investment grade corporates have termed out their borrowings over the last two years). Our views on recession also point to the start of a new default cycle which is not yet fully priced. That said, certain pockets of the market are starting to show some value, especially in investment grade credit where we believe spreads are already pricing in a recession.
We are continuing to avoid high yield credit as we see this as the market segment where recession and rising defaults could trigger tail-risks if the sell-off becomes disorderly. During a stressed credit sell-off, illiquidity can cause spreads to widen substantially and price in far more dire expectations, like the pricing of a depression in 2020 and 2008.
Risks to bond yields continue
Despite the renewed sell-off in bond markets in August, we continue to see risks to yields in both directions. These are still slightly skewed to the upside (in yield terms) given the disconnect between nominal growth, policy tightening and the level of bond yields. Against this though, the Fed’s balance sheet will contract in coming months, and this will serve to help tighten monetary policy and moderate the overall extent to which rates would need to rise.
We continue to watch inflation momentum, energy prices and growth with any sign of moderation being a potential catalyst for a rally. We prefer Australian duration as we do not believe the economy/housing market can handle the level of rates being priced in and given how aggressive the Fed has been relative to the RBA. In addition, the world could roll over into a recession before the RBA reaches their terminal rate. We continue to hold some duration and would describe this position as a bit short of neutral, albeit we have trimmed slightly in recent weeks. This did drag on absolute returns in August. Our cash weights remain high.
Consistent with our overall defensive positioning, our preference for the USD as the safest currency in this environment paid dividends during the month. We continue to hold this position alongside the JPY, another typically strong performer in a risk off environment. We do see some emerging market currencies as helpful diversifiers with upside risk should China stimulate significantly, and Asian markets turn, but this is offset by a short position in Chinese renminbi (CNY).
Remain cautious shorter term
In summary we expect weakness to continue for a while yet. We can’t avoid the impact but have tried to minimise the drawdown. To this end, while the strategy returned -0.50% in August, we would frame this against returns of -2.7% in broad fixed income indices and -4.1% in global equities (MSCI World). The key though is to try and ensure we position ourselves to take advantage of the more positive story that we expect to unfold. This positive story is simply that risk premia are rebuilding, yields are rising and there will be some attractive medium-term opportunities emerging. We just don’t think we’re at this point yet.
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