Pressure Continues to Build
Stephen Lingard - Oct 26, 2023
As we wait for the inflation bubble to pop, market dynamics are shifting to lower-risk assets. Discover why alternatives are gaining ground as equities lose their luster.
Equity implied volatility is in the mid-teens, suggesting a possibility that investors have become complacent. This is happening despite a relentless increase in market interest rates, which is slowly building pressure on the system. After a year and a half of policy rate increases, and later, stern warnings from economists, central bankers, and investors alike that a recession was coming, most hard economic data like GDP and employment is signaling anything but. This has forced the Federal Reserve (the Fed) and other central banks to keep up their hawkish rhetoric, especially as soft data like the Purchasing Managers’ Index (PMI) have begun to recover after breaking down into contraction territory earlier in the year. What are investors to do? To date, the only recession has been in U.S. corporate profits as the S&P 500 churns towards year-end producing broadly the same earnings per share as seen in 2022, meaning positive market returns this year have been valuation-driven. The biggest questions from investors now are: When will earnings recover their momentum? Will interest rates and inflation back off, allowing valuation some breathing room? Will bond/equity correlations revert to their more negative historical relationship? Is TINA (There Is No Alternative) still a support for equity markets? Let’s break these questions down one at a time to help chart our portfolio positioning going into the fall.
Earnings (sputter) – U.S. corporate earnings have flatlined this year despite average U.S. nominal GDP growth of +8% since the end of 2021 as profit margins compressed. Higher interest, wage, and other input expenses have weighed on corporate bottom lines. However, it now looks like margin deterioration may be behind us, having stabilized in the last quarter. Still, nominal growth is now slowing as inflation and real GDP growth head lower. This challenges the assumption the market currently has for earnings growth into next year of ~10% with the likelihood for a slowing of the economy given the lagged effects of monetary tightening.
Inflation/Interest rates (falling) – The good news is inflation is heading in the right direction, which may lead the Fed and other central banks (eventually) to stop tightening and potentially even ease. Core inflation measures like personal consumption expenditures (PCE) have been more stubborn in coming down than headline. However, progress now is being made, with the most recent figure falling to 3.9% year-over-year (although still well above the Fed’s 2% target). On the interest rate front, while policy rates are in the process of peaking, market interest rates further out the yield curve have continued to reprice rather abruptly, with 10 and 30 year yields up 140 and 125 basis points (bps), respectively, from lows in April this year. This bear steepening of the yield curve has unsettled stocks, with the SPX down almost 7% from its recent peak. Absent a hard landing, these levels for inflation and longer-term interest rates may stay somewhat elevated, causing more pressure on stock market valuations (mostly a U.S. concern).
Bond/Stock correlations (break) – The classic 60/40 portfolio has served investors well for many decades, but it tends to work best in low inflation regimes which, we are likely turning the page on today. Not to say inflation is out of control like it was in the ‘60s or ‘70s, but we are more likely to see 3% inflation than the sub 2% inflation we enjoyed for much of the past 20 years. This new inflation regime is due to de-globalization/geopolitics (just-in-case as opposed to just-in-time), a resurgence of fiscal spending, a period of higher wage growth, and higher commodity inflation. More inflation historically has increased the bond/stock correlation, weakening the benefit of diversification (but important diversification benefits remain).
TINA (There is No Alternative (to equity)) - TINA’s cousin TIAA (There Is An Alternative) has moved to town to offer more interesting risk-adjusted returns than equities alone. With overnight cash rates and short-term government and credit securities offering between 5-6% with little to no risk, the hurdle for owning equities has become higher, making asset allocation a more interesting question. Add to this a period of underinvestment in natural resource capex over the past decade due to ESG concerns, and you have some interesting opportunities in commodities. Finally, other alternative assets like private equity, debt, infrastructure, and real estate have become available to the individual investor by new regulation and products, adding to an asset allocator’s toolbox to help in the challenge to create strong, risk-adjusted return portfolios for clients.
Positioning and Opportunities
Given the higher-than-normal probability for stagflation (below trend growth, above trend inflation), we have taken the following actions in our portfolios. We have reduced our exposure to equities and further increased our positions at the front end of the government and credit yield curves, as well as cash. We believe it makes sense in the current environment where cash yields are similar to equity yields. Commodities and private assets should also receive more allocations this fall.
Within equities, we have trimmed U.S. equities, which are more susceptible to higher inflation/interest rates than are other value-oriented markets that may benefit from higher for longer global interest rates. Canada, Japan, and Emerging markets are currently favoured relative to the U.S. and Europe. In terms of investment styles, we are neutral on growth/value but favour quality and low volatility. We expect the latter to likely benefit from an increased market volatility environment later this fall. Despite the anticipated slowdown in Western economies, including Europe, U.S., and Canada, we are keeping cyclicals vs. defensives neutral, as the medium-term opportunity in energy, in particular, looks interesting, and lower interest rates, which would favour defensive sectors, looks to be a while off.
As a result of the recent enhancements made to the Assante Private Portfolios program, we aim to have significantly more control over portfolio positioning moving forward. While keeping this goal in mind, it is important to understand that our target positioning may not be fully reflected within the portfolios immediately following the asset mix change, as a transition of this magnitude needs to be conducted in an efficient and thoughtful manner. We are confident that portfolio positioning will gradually approach target through the remainder of 2023 and into next year.