The misalignment of policy setting, economic outcomes and asset prices has been a consistent concern for some time. While it has been easy to be confident that this was unsustainable and would break at some point, the more challenging questions to answer were: When and what would be the catalyst? and then: How broad and pervasive would the re-pricing be? Position too early and you missed out on the bull run of 2021. Position too late and the downside in 2022 would be significant. Inflation would always present the biggest challenge to central banks and their aggressive post-COVID accommodation. The inflation that arrived in late 2021 has been turbo-charged by surging energy and food prices and further disruptions to supply chains in 2022. Now markets are finally unravelling as central banks have no option but to ‘take away the punch bowl’.
June was an ugly month – one of the ugliest. What made June different was that markets shifted from primarily focussing on surging inflation (and how fast and how high rates would need to rise to contain it) to contemplating the consequences of tighter policy and the growing risk of recession. The combination pushed asset prices for both equities and credit lower across the month. It was a more staggered response in the sovereign bond market, with higher inflation driving yields initially until recession fears were elevated following the Fed’s 75bp rate hike. Overall, there were few places to hide.
Unfortunately, we don’t think that the pain is behind us. The significant sell-off in equities in June and the year thus far has seen headline valuations improve. However, this mainly reflects a de-rating of the market to align with the rise in actual and expected interest rates, against a high and problematic inflationary environment. Earnings and the market’s forward earnings estimates are yet to deteriorate materially, and we expect them to do so, to align with the expected economic slowdown and material recession risk globally. Central banks around the globe aren’t reacting (yet) as they have over the last decade to market dislocation. This is because monetary policy is firmly focussed on curtailing rampant inflation. As such they have limited policy flexibility in this context. Unlike the GFC or the COVID market crises (where there were clear systemic issues in the case of the GFC or an exogenous shock in the case of COVID), economies face a relatively classic recession scenario, whereby pro-cyclical policy leads to inflation, which leads to policy tightening and eventually leads to recession. Energy and supply chain disruptions are exacerbating the inflation prognosis but are not the root cause. We expect revised earnings expectations to be the driver of the next leg down in equities globally. We think emerging markets can de-couple to a degree, as valuations are better and China is stimulating, albeit this will need to continue for the decoupling to continue. The key risk to this negative equity view is that inflation moderates and earnings hold up, but we place a low probability on this outcome.
Credit tells a similar story
While credit spreads (and total yield) have risen, we see a significant risk of further material spread widening in both high yield and investment grade markets. Defaults have so far remained low, reflecting low interest rates and up to this point strong profits. However with the cost of refinancing rising and profit growth slowing (and likely contracting) as costs rise and sales decline, we expect some further distress before a clear buying opportunity emerges. We are seeing some selective ‘buy and hold’ opportunities emerging but caution is warranted.
We are becoming more constructive near term on sovereign bonds. This is because the sell-off in bond markets in recent months has extended to a point where we believe that key sovereign yield curves are pricing sufficient monetary tightening to slow the economy enough to alleviate cyclically induced inflation. Consistent with this, we have seen a moderate rally in bonds towards the end of June. That is not to say that the market will not overshoot (as it has a habit of doing) or that central banks won’t overtighten, but we do think the risks are starting to look more balanced than they have for some time. The market is still trying to ascertain where the peak in inflation is and where it will settle going forward. We believe that once the market focus shifts fully from inflation to growth, yields could start to decline, even in the face of elevated inflation prints – that is, bond yields will lead the inflation narrative on the way down. Keys to watch here are inflation momentum and energy prices, with signs of moderation of growth being a potential catalyst for a rally. This also means that the bond / equity correlation will shift to negative again.
Against this backdrop, we continue to prefer defensive currencies – mainly the US dollar but also the Japanese yen.
Source: Schroder, MSCI, Refinitiv from 31 December 2021 to 30 June 2022. Based on the gross return of Schroder Real Return Fund. Global high yield is represented by Bloomberg Barclays Global HY xCMBS xEMG 2% Cap (AUD Hedged), AusBond Composite is represented by Bloomberg AusBond Composite Index, Global Agg AUD Hedged is represented by Barclays Global Aggregate AUD Hedged, Global Agg Corp AUD Hedged is represented by Barclays Global Aggregate Corporates AUD Hedged, Gold is represented by Gold Bullion LBM $/t oz. Past performance is not a reliable indicator of future performance.
The biggest challenge from a portfolio construction perspective in June (and more broadly so far this year) has been the breadth of the sell-off, which has left limited places to hide (only cash, commodities and US dollars offering any real return solace). Equities, bonds and credit have fallen significantly so any exposure (no matter how small) has hurt returns. The alternative, and more risky, approach would be to ‘short’ key asset classes (as hedge funds are able to) but this is not available to us as a ‘long-only’ strategy.
Mitigating the impact
All this said, we entered June in a very defensive position with elevated cash levels near 40%. To put our recent actions from an asset allocation level into context, since late 2021 both our equity and credit exposures have close to halved. More specifically, our equity exposure has declined from 37% late last year to around 19% in mid-June. Corporate credit has declined from 40% to less than 20% over the equivalent period and cash holdings have increased by 30%. These changes put the portfolio in a good position to mitigate the impact of the carnage across most asset classes, but insufficient to avoid some damage – given its breadth.
As outlined above, we expect more weakness in equities and credit (particularly the riskier parts of the credit universe), but we think risks around sovereign bonds are shifting. We are not making material changes to positioning on the risk side and are waiting for markets to start to better reflect recession risk on earnings. While the more speculative parts of markets have fallen sharply, the drawdown in key equity markets like Australia and the US are moderate compared to past recessions and we’re still early in the tightening cycle. That said, we are continuing to add moderately to our duration positioning, lifting our overall portfolio duration to around two years. This is well above the 0.75 years that prevailed in 2021, but well below the peak of 2.75 years in 2020 – as COVID impacted initially.
