Multi-Asset Strategy Quarterly – July 2023

All the signs point to recession

Iain Cunningham – Co-head of Multi-Asset Growth, Michael Spinks – Co-head of Multi-Asset Growth

Our market outlook remains cautious with defensive positioning across multi-asset portfolios driven by an expectation that the significant policy tightening that has taken place over the past 18 months globally is likely to act as a material headwind to growth in the coming months. This is based on our tested belief that policy is a leading indicator of the outlook for growth and inflation. When policy is ‘tight’, future growth and inflation will slow. When policy is ‘loose’, future growth and inflation will accelerate.

In the developed world we have witnessed a material increase in interest rates, and bond yields, to the point where we would describe policy as being notably ‘tight’. Policy action typically has a lead on the economic data of about 12-18 months, and therefore we are yet to see the full impact of the rapid tightening that has taken place since early 2022. In terms of the evidence that policy is tight, money supply aggregates in both the US and Europe have been contracting. Rapid money supply during the pandemic caused a nominal boom in the economy, while notable money supply contraction is likely to have the opposite impact. In the case of the US, this is the first occurrence since the 1930s and is one of the contributors to stress in the US regional banks. One cause of money supply contraction has been central banks running down their balance sheets through quantitative tightening with about a US$2 trillion decrease in the last 12 months. A further US$2 trillion of likely quantitative tightening over the next 12 months will remain a headwind to monetary aggregates.

Recession indicator 1: Tightening money supply not good for growth

Source: Ninety One, June 2023.

The evident lags of monetary policy tightening could be more extended versus history, due to the exceptionally low level of real rates at the start of the tightening cycle and the extent of the COVID related policy stimulus which has provided a spending buffer for households. The credit channel is something we monitor closely as a key component in the expected stalling of growth in the months ahead. In the US, year-to-date, bankruptcy filings are at the highest level since 2010 and we expect default rates to accelerate from here, particularly for highly geared borrowers with floating rate exposure and near term funding risk. Fifteen months since the first rate rise, the US credit impulse has rolled over sharply; a process we expect to continue as lending standards have tightened and the demand for borrowing has moved to levels consistent with prior recessions.

Recession indicator 2: Falling demand for credit is not good for growth

Source: Ninety One, June 2023.

Recession indicator 3: Falling commercial and industrial loans

Source: Ninety One, June 2023.

US Economy: soft landing? History implies the odds are low

Growth data has held up so far, but the major macroeconomic forces described above typically lead and we expect a broader slowdown to emerge in the coming 6-12 months, notably in areas of the economy that have to date held up, such as the labour market and the services sector. Labour markets have remained extremely resilient, given significant excess demand for labour. However, there are tentative signs that weakness is occurring, notably in some of the more leading elements of the labour market data such as initial claims. Typically, central banks have responded to weaker economic data releases with policy easing, but still elevated inflation means the banks have less flexibility and are likely to be materially restricted in their ability to support growth and increase liquidity at a time when the market expects action, as it has become accustomed to in the post-GFC era.

While our outlook is more cautious, investors appear relatively optimistic with a pause in the negative earnings revisions that have been evident over the past 12 months. At present, there is only a marginal year-on-year percentage decline in global earnings expected, while earnings declines during historical periods of slowdown, consistent with the forces described above have been notably deeper. We therefore expect investors to be disappointed with earnings over the coming 6-12 months.

As a result of these dynamics our strategies remain underweight equities, with a bias towards the Hong Kong and Chinese markets where valuations are attractive, and policy appears to be ‘loose’. In fixed income, we remain overweight defensive duration given our outlook for a weaker growth profile however we are focused specifically on high grade markets such as Australia, Canada, New Zealand, South Korea and Sweden. Household balance sheets in these countries have dramatically increased leverage over the years and typically financed themselves at variable rates which is a source of imbalance, and we expect their economies to be impacted sooner and harder than the US economy. We express a similar theme in currencies and maintain a defensive stance with long positions in reserve currencies (US dollar, Japanese yen and Swiss franc) vs. the currencies of more economically vulnerable countries (Australian dollar, Canadian dollar, New Zealand dollar and Swedish krona).