3 Nov 2022
Iain Cunningham – Co-head of Multi-Asset Growth, Michael Spinks – Co-head of Multi-Asset Growth
The environment for risk assets has remained challenging through the third quarter and investors hoping for a US Federal Reserve (Fed) ‘pivot’ through the summer were left disappointed after the Fed Chair’s annual speech at Jackson Hole. Jerome Powell made it clear that inflation fighting was priority number one and warned that businesses and consumers could feel pain in the coming year, adding that history has been unkind to Fed Chairs that have backed off before finishing the job and regaining price stability. This reduced the likelihood of a ‘pivot’ anytime soon. Developed market equities and bonds sold off heavily, finishing lower on the quarter, post a strong rally through July and August. Emerging markets and China struggled over the same period due to a combination of USD strength, the ongoing zero-COVID policy in China and concerns that policy stimulus is not yet sufficient to offset these headwinds.
We came into this year highlighting three main concerns for asset markets and the global economy: slowing growth in China as a function of material prior tightening, developed market central banks, particularly the 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.
We continue to believe that it makes sense to countercyclically allocate capital into Chinese and Hong Kong risk assets, with a medium-term horizon. Policy dynamics are at the opposite end of the spectrum versus early 2021, with credit being expanded, incremental support for the real estate market emerging and a more constructive policy attitude towards regulation. We continue to use volatility to accumulate positions supported by our longer-term thematic road-map as a result.
In terms of the Fed being behind the curve, we believe it’s becoming likely that it is moving ahead of the curve as its policy path in the next six months should be sufficiently tight to slow the US economy down, in the process probably leading to recession. Evidence is emerging across leading indicators, monetary aggregates, and corporate profit announcements that growth is slowing, but the effect of most of this year’s tightening will likely be felt in the first half of 2023 due to policy lags. Quantitative tightening is now also beginning to pick up pace, presenting a direct headwind to asset prices. In addition, the Fed is focused on backward looking economic releases such as unemployment and inflation. Together these increase the risk of a period where growth and earnings are weakening, potentially sharply, while Fed policy remains tight or continues to tighten.
Figure 1: US 10 year treasury vs.breakeven yields (%)
Figure 2: US 10 year real yields (%)
Source: Bloomberg, September 2022
On valuations, there is a lot of value, coupled with policy support, in select Asian equity markets. In US equities, we would characterise this year’s sell-off so far as a valuation reset, with the market moving from being overvalued to more reasonably valued, based on current earnings. This has been driven by rising discount rates. Further downside from here will likely be driven by earnings downgrades in our view, and we remain cautious on developed market equities, remaining notably underweight equities as a result.
Figure 3: US equities: further derating required under central scenario
Source: S&P 500, September 2022
In fixed income, we would note that real yields in several developed market government bonds are the highest they have been in over a decade, while recession risk is rising. We have added exposure here, particularly in the government bonds of developed economies with household leverage and housing market imbalances, where higher rates appear to be beginning to weigh. Defensive duration exposure is now in line with typical (or neutral) allocations as a result.
Figure 4: Household debt to disposable income ratios
Figure 5: House price indices
Source: Bloomberg, September 2022
General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results.
Specific risks. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.