26 July 2022
Iain Cunningham – Co-head of Multi-Asset Growth, Michael Spinks – Co-head of Multi-Asset Growth
The first half of 2022 has been a tumultuous one for capital markets, with both equity and bond indices posting significant declines. We came into this year highlighting three main challenges for asset markets and the global economy: slowing growth in China as a function of material prior tightening, developed market central banks – particularly the Federal Reserve (Fed) – being substantially behind the curve on inflation, and extended valuations across asset classes. As a result, our portfolios were positioned broadly with underweight equity, underweight fixed income and long US dollar versus Asian and European currency positions, as we sought to benefit from macro policy divergence between the Fed and other major central banks.
Thinking through each of these market moving forces, it’s clear that change has either taken place or is underway. In terms of China, we detailed earlier this year that policy makers had clearly pivoted. 2021 was a “window of opportunity to address structural imbalances” for Chinese policy makers, which involved taking policy tight in aggregate and a whole raft of market unfriendly policies. 2022 has, however, been identified as a year where “stability is the top priority”, and although COVID remains a challenge for China, policy is being eased and unfriendly policies are being parked to improve confidence and support growth. As a result of this, and attractive valuations in the region, we have been accumulating positions and moving overweight in Chinese and Hong Kong-listed equities through the first half of this year.
In terms of the Fed being behind the curve, change is also now underway. After a handbrake turn in policy, the Fed has moved from printing money in January to some of the largest hikes in the Fed Funds Rate in decades, in addition to also enacting quantitative tightening. This has pushed financing rates across the economy sharply higher and tightened financial conditions. We believe evidence is emerging that the implementation of positive real market interest rates by the Fed is beginning to effect growth and inflation indicators.
Money supply, which had been growing at c.20% p.a. in the two years post the COVID shock and – in our view – has been a major source of inflationary pressures, has just contracted on a six-month rolling basis. We expect this will show up in weaker growth and inflation in six to 12 months. Similarly, the US manufacturing new orders to inventories ratio has moved into contraction and market-based measures of US inflation expectations, such as breakeven rates, have now been posting convincing declines. It appears that the Fed is no longer behind the curve, but the next question we have to ask ourselves is will this bout of central bank inflation fighting push major developed market economies into recession and if so, how deep will it be? We’re adopting a cautious approach here, given that inflation measures are lagging, and the pace of tightening has been swift.
The implication is that we may soon enter an environment where both growth and inflation are weakening. As a result we have begun to close our underweights to duration. In FX, we have also substantially pared back long US dollar positions, due to our expectations that the US economy will be decelerating into 2023, while we expect China to be reaccelerating.
On valuations, there has been a significant adjustment in markets year-to date. In select developed market government bonds, we see real rate premia present now for the first time in years. In credit and equities, spreads have expanded, and multiples have derated, but we’re not yet convinced that valuations price a ‘tight’ liquidity environment, which we’re heading into. The natural process of a central bank tightening to choke off excess demand and pricing pressures is in motion, with the next phase being a slowdown in both growth and inflation. This leads us to believe it’s too soon to sound the all-clear for developed market risk assets.
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