Fed speak: The not-so-subtle art of persuasion
Equity markets began to soar ahead of the all-important monetary policy symposium in Jackson Hole, Wyoming. The rally in markets after better inflation and economic data had run its course when the Fed chair spoke to bankers and reporters. He made the following key points:
· The US central bank has an “unconditional” and unwavering commitment to bring down inflation.
· Economic momentum and in particular the labour market remains strong.
· Recent inflationary data has improved but “falls far short” of a turn in trends.
· The Fed will be patient in unwinding tighter policy when the economy slows.
While there was nothing surprising in Mr Powell’s speech, it provided ammunition for the bears to re-exert influence. With a slew of economic data due to be reported in the next few days, investors will try to interpret the likelihood of another 75 basis-point rate hike in September. The August inflation print has added importance as it could impact the pace of Fed policy and asset prices for the rest of the year.
On the other side of the pond the news looks far worse. Inflation has gained further momentum in recent weeks due to spiralling natural gas prices and the lifting of energy price caps. UK and European energy infrastructure is ill equipped to deal with the consequences of the war in Ukraine. Electricity prices are linked to the price of natural gas, which during the winter months leads to an escalation in energy costs for households and businesses.
The European Union is trying to limit natural gas demand and bolster alternative sources of electricity production. Emergency handouts for households and utilities are being considered along with a renationalisation of power generation.
UK Politics:
The power vacuum at the top of UK politics has created additional unease for UK households. The near doubling of energy bills will push millions into poverty and drive-up wage demands across the economy. The Bank of England expects UK inflation to peak at 13% in the fourth quarter, but private sector forecasts have been revised much higher.
The immediate impact of political dithering has been felt in currency and fixed income markets, where UK gilts have performed far worse than global bonds and sterling is close to its post pandemic lows versus the US dollar. The lack of a clear plan this close to winter adds fuel to an already precarious backdrop.
Source – Bloomberg
Positioning:
We started the year on a defensive footing, with a reduction in high yield, emerging market, and Asian exposures. We bolstered these steps by reducing UK mid-cap allocations and adding duration to our global government bond holdings in June.
A global recession has been our base case for most of this year. Asset allocation decisions have been made harder by the sharp sell-off in government bonds. We have taken measures that will help when the global economy begins to contract. The uncertainty around UK and European energy costs, China’s zero Covid policy and the quickly deteriorating macro back drop makes it critical that we continue reducing areas of unintended risk within portfolios.
Conclusion:
As we navigate the maze of multi-asset correlation, the mind naturally focuses on areas that have had the largest historical drawdowns. These have included UK Mid-Caps, UK Property, Asian Equities and UK Large Caps. Note that many of these declines were seen during the 2008 global financial crisis. The drawdown characteristics of fixed income are notably different from equities, and we can take advantage of this characteristic as we aim to enhance longer term portfolio outcomes. We remain on a defensive footing and will continue to reduce portfolio wide exposures to the riskiest asset classes.
Source – Bloomberg – 20 year max draw down and volatility data sampled monthly