Commentary: A bear market in everything is a reset

November provided a welcome rally, triggered by the weaker than expected US inflation data, reversing negative price momentum across most financial assets. Investors were quick to price in a slowing of the rate hike path for the US Federal Reserve, resulting in materially higher asset prices.  We were pleased to be able to capture a greater portion of the move as we increased equity and credit exposures, following the market declines in September when our valuation models suggested markets were close to fully pricing a recession in 2023.

As we’ve noted before, market cycles are not linear – they incorporate deviations and short-term gyrations within larger trends. Thus, strong rallies are common within bear markets. Behavioural factors such as negative sentiment and short positioning have a habit of racing ahead of the fundamentals, leading to reversals when data surprises and challenges consensus thinking. Our economic base case remains a recession in the middle of next year, with the risk for both a faster and more severe downturn. This view is primarily driven by the unprecedented speed, magnitude and synchronisation of monetary policy tightening and is supported by our US recessionary dashboard, which continues to flash ‘red’ with 60% of components signalling a recession.

Pain leads to gain

The first ten months of this year have had their challenges, but with all asset classes (with the exception of cash, commodities and the US dollar) materially negative this year, there is now an opportunity for a reset in valuations. While painful this reset has created attractive entry points in assets that have in our opinion been trading at unjustifiable valuations over the past several years. We have recently re-entered positions in high-yielding credit markets as well as re-built our investment grade credit and equity exposure, all of which contributed positively to performance in November. However, uncertainty around the path of inflation remains high and with recession in 2023 as our base case, we expect asset price volatility to remain high. Accordingly, we have  taken advantage of the recent rally to add some downside protection with the purchase of put options across equity markets.

Valuations have improved and increased potential returns across almost all asset classes in our framework. Most notable is fixed income, where expected returns have risen to the highest levels in over a decade. Importantly, these higher expected returns will likely increase two elements of multi-asset portfolios – investment performance and asset allocation flexibility. Higher bond yields allow for the re-emergence of fixed income carry and income, something that has been absent during the quantitative easing period since the GFC. This will also enable a wider and more active use of bond allocations going forward, providing more consistent returns. This is especially the case once the correlation between bond and equity returns shifts from positive to negative as inflation declines.

Awaiting clearer signs

While we have raised our risk asset exposures, we are still waiting for clearer signs of which way the economic cycle is shifting. Apart from the obvious growth and inflation numbers, two factors likely to determine market direction over the shorter term are monetary policy and corporate earnings. Monetary policy will remain a counter-cyclical factor, whereby central bankers will continue to tighten financial conditions in order to quash demand and inflation. This means that good news on growth is actually bad news for asset prices. Corporate earnings on the other hand have been a bright star this year as companies pre-empted the higher rates, front loading their debt issuance and hoarding cash to endure any potential storm. However, as rates have risen there are now signs that consumer demand is deteriorating via diminishing savings and increased retailer price discounting to move excess inventories. There are also early signs that the labour market is weakening, with a move from full-time to part-time jobs as well as an increasing number of companies announcing job cuts in the US.

While we move through this period of monetary policy and economic cycle transition our aim is to remain active. This is particularly so with asset allocation, as we expect risk assets to trade more range bound rather than in one direction. We expect volatility to remain elevated and present opportunities to increase or decrease risk  across asset classes, allowing us to rotate our preferred exposures. This is especially the case in fixed income, where we continue to see attractive yields creating opportunities – especially in credit markets. Underpinning this remains our negative economic outlook, which will keep portfolio risk lower until we see a material improvement in valuations or improved visibility on the depth and duration of recession. Alternatively, we also expect to reduce risk if asset price appreciation is not supported by improvements in the fundamental growth outlook.

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