“History doesn't repeat itself, but It often rhymes” – Mark Twain.
Risk assets suffered their worst start to the year since the 1970s. The convergence of falling bond and equity prices created a toxic environment for asset owners. Central banks, having been behind the curve for much of the year, reasserted their commitment to price stability. The Federal Reserve raised rates by .75% at its June meeting, taking the all-important US benchmark rate to 1.75%. US policy rates are expected to reach 3.5% by year end.
The Fed’s actions have been driven by the inflationary surge which began in the summer of 2021. The war in Ukraine has pressured commodity supplies adding another leg to a difficult backdrop for central banks. The chart below highlights a divergence in core and headline inflation. Core inflation, the Fed’s preferred measure, looks to be peaking even as headline inflation continues higher. While central banks lack the ability to impact commodity supply, their actions are starting to have a broad economic impact which is causing a decline in commodity demand.
Source – Bloomberg
Source - Bloomberg
The US manufacturing managers’ survey has slowed sharply in recent months. The new orders component of the survey is now in recession territory, and we expect goods inflation to abate as inventories have started to build.
Consumer spending, adjusted for inflation, has slowed across the world as the rising cost of living has impacted people’s propensity to spend. House prices have started to fall in over heated markets and new mortgage applications in the US have shown sequential deterioration. Monetary policy is still a powerful tool against the scourge of inflation, and we expect inflation expectations to remain anchored despite tight labour markets.
Commodity demand is driven by global consumption trends. The chart below highlights how various commodity prices have reacted to incoming economic data. Industrial metal prices (copper, iron ore and nickel) have fallen sharply in recent weeks. Energy prices, a key component of headline inflation, are down from their peak even as US driving season gets underway.
Source - Bloomberg
Life without a Fed put and factor signals:
Source - Bloomberg
Falling valuations driven by rising bond yields have upended the multi-year outperformance of growth and momentum strategies in 2022. Our factor focused investment process instructed our decision to exit growth funds in March 2021. Having benefited from a decade of falling inflation and interest rates, growth managers have failed to adapt to the recent rise in inflation. Their returns have retraced a decade’s worth of outperformance in six short months. Their undoing highlights the need for a factor aware process to fund selection.
Value, dividend, and quality focused funds have outperformed this year. Value outperformance has come mainly from commodity sectors as banks haven’t fared well. An increase in interest rates is good for bank margins but comes with the risk of recession. Bank equities are telling us that credit costs will rise significantly as we enter a policy induced economic slowdown.
Utilities form a large part of the global infrastructure allocations we added to portfolios in January. The sector has outperformed this year as investors have sought the safety of government backed dividend streams. While rising interest rates have historically hindered utility stocks, a sharp increase such as the one we are now encountering, can force investors to seek safety that the group provides. Healthcare and consumer staple stocks have also done well as investors seek the relative safety of their revenues.
Bonds, diversification and duration:
Bonds, a mainstay of multi-asset portfolios, have failed in their role as diversifiers in 2022 and have accentuated portfolio volatility. We started the year with half our global and corporate bond allocations in short duration bonds. We were worried about inflationary trends and the action central banks would take to contain them. These allocations have helped mitigate some of the damage to portfolios this year.
While we expect headline inflation to continue to be an issue in the near term, we feel the Federal Reserve will deliver on its promise to maintain price stability. The speed with which the Fed adjusted market expectations after the May inflation number showed the veracity of their commitment. Core inflation, which captures most consumer expenditures has started to wane. Incoming economic data has caused a decline in commodity prices in recent weeks.
These developments informed our decision to neutralise the duration of our global bond allocation in June. We have maintained a short duration position for half our corporate bonds as we feel the risk of spread widening remains.
Source - Bloomberg
It is too early to call a definite turn in the bond market, but there is compelling evidence to support a case for an economic slowdown. We feel bonds can once again serve their role as the diversifier of choice in multi-asset portfolios.
In addition to adding duration to our global bond allocations in June, we cut our exposure to UK mid-caps by selling down TM Crux UK Special Situations and Chelverton UK Growth. The proceeds were invested in a UK All-Share Tracker. The shift to larger companies helps mitigate liquidity risk within portfolios and this is something we are keen to do as the global economy starts to slow.
You will be aware that we started 2022 by reducing sources of unintended risks within portfolios. We sold emerging market equity allocation, reduced high yield and Asian equity position and sought safety in larger US allocations. We introduced much larger allocations to global infrastructure and avoided holding gold and linkers.
These decisions have helped portfolios deliver performance in line with their benchmarks during a period of immense market volatility. We used the summer rebalance to reintroduce gold into portfolios. Where gold could not be held, we chose to use a long-dated gilt tracker. Note that extending duration, reducing small cap exposures and buying gold or long duration gilts is directionally consistent and has better prepared portfolios for a slowing economy.
The next phase:
Our investment process is built around inflation and bond yields. A large part of the move in bond yields is driven by the implied move in policy rates. Policy rates aren’t set in a vacuum and react to incoming inflation and economic data. We have spoken to several fixed income managers in recent weeks.
1. Algebris Financial Credit Fund
2. AXA ACT Green Short Duration Bond Fund
3. Barings- Emerging Markets Debt
4. RL Global Sustainable Credit Fund
5. T. Rowe Price Global Impact Credit Fund
6. UBAM – Global High Yield Fund
7. Polar Capital Global Convertible Fund
8. Aviva Investors Global Convertibles
9. Bloomberg EM Fixed Income Forum
10. Allianz Strat Bond
Expected returns for investment grade credit, high yield, EM debt and convertible bonds have risen significantly in 2022. These asset classes have various issues but are more attractively priced given the year-to-date selloff. Global high yield, an asset class we reduced in January, has fallen sharply in 2022. Underlying yields have risen significantly but could rise further as default risks rise. We group high yield with EM debt and convertibles. Given policy rates capture most of the year to date move in yields, we will focus our efforts on extending duration before considering credit and equity risk.
The year-to-date decline in portfolios has been particularly unnerving as it has been accompanied by the highest inflation in 30 years. While asset prices were mis-priced for a surge in inflation, they now offer attractive forward-looking returns. We believe the Federal Reserve will deliver on its commitment to price stability which will engender a period of above average investment returns when monetary policy is eventually eased. We believe that a global recession in the next 12 months remains a high probability outcome and we will position portfolios to reduce sources of unintended risks. We have neutralised our global bond duration in recent weeks and will seek to extend duration in other areas before considering credit risk. Our investment process has helped portfolios navigate a volatile first half and we believe in our disciplined road map for the rest of the journey.