This month saw us reduce our allocation to REITs and for the first time move to an underweight position in listed markets.
Our asset allocation consultants, Heuristic Investment Systems, explained that this is due to the growing drawdown risk with REITs as bond yields have risen.
Financial conditions have tightened considerably, with global equities down 15-20 per cent and Australian equities down 5-10 per cent year to date before a late rally into the end of May. Spreads in high yield credit have widened approximately 150 basis points or 1.5 per cent and the USD has appreciated approximately 10 per cent.
These are dramatic moves. The US bond market yield curve and credit spreads are now consistent with a 20 per cent probability of a recession. If official interest rates rise to the levels predicted by the markets over the next 12 months, the probability of recession rises to 70 per cent.
In Australia, the RBA is expected to increase rates to a “neutral” level of 2.5-3 per cent by calendar year end.
Volatility has driven large movements across the board in asset classes, but Australia appears to be in a stronger position than many areas globally.
UK AND EUROPEAN SENTIMENT
Will Hamilton has been visiting Wealth Managers in Europe and was shocked at how negative sentiment is. Whilst Europe is feeling the price increases and supply constraints because of the Ukrainian war directly, it is also having a very negative impact on confidence there.
One observation from Will is that the UK is probably in recession already, whilst the rest of Europe is drifting into recession.
Capital Economics in London is particularly bearish, having cut their 2022 GDP growth forecast from 4 per cent to 2.8 per cent, and seeing some industries in Europe already in recession. They see inflation coming down due to the high base effects, but settling at higher levels than currently anticipated, due in part to the very real climate emergency and its impact on food and other prices.
They are also very negative on China, as its service industry is moribund and the stimulus announced there so far is quite small.
In May, Will also attended the Fund Forum International conference held in Monaco, which focussed firmly on current market turmoil and the outlook for the post-pandemic economy.
One presenter captured audience attention by characterising the trend as moving from a ‘goldilocks’ environment to that of ‘big bad wolf’ with three big themes (or ‘bears’) dominating the conference debate: inflation, interest rates and the war in Ukraine.
INFLATION AND INTEREST RATES
Rising inflation is a function of a stronger than expected recovery fuelled by the enormous policy stimulus from COVID. Constrained supply is a legacy issue from COVID exacerbated by the war in the Ukraine.
Those of us who have lived long enough can recall the 1970s oil crisis and inflation shocks – comparing what is going on today in 2022 with conditions then. But the big question is how central banks will respond and whether they will sacrifice growth to ensure a wage price spiral is avoided.
Conference attendees noted that central banks are behind the curve. They have been late in reacting and we have seen a global repricing of assets commencing with bond markets.
The lesson we can learn in such circumstances is that historically, two thirds of rate cycle increases have led to a hard landing.
At the Monaco Conference the most interesting commentator on the Russia/Ukraine war itself was the former head of MI5, Baroness Eliza Manningham–Buller.
Baroness Manningham-Buller stated that Vladimir Putin believes that losing the Soviet Union was the greatest loss of the twentieth century. She argued that Putin overestimated the competence of the Russian army, underestimated Ukrainian defence, and believed the West wouldn’t unite and stay the distance.
The Baroness however sees the climate emergency as the number one long term issue in the world. Why? Governments are not working together, risk of increased disease, food security, water security and migration are all threats to global peace.
Meanwhile, Thierry Malleret, Global Strategist to World Leaders, sees the war in Ukraine as a mammoth financial risk due to:
- Sanctions – the complete weaponization of finance through sanctions, which Russia sees as a military reaction.
- US Dollar – the ‘dollarisation’ that has prevailed is being questioned by many countries, with fear of sanctions and at worst, the seizure of assets.
- Protracted War -the longer the war, the greater the risk of escalation and therefore the greater the threat to the global economy.
- Falling GDP – Russia and Ukraine combined were 3.4 per cent of global GDP but the impact on supply chains and inflation is a negative 1.5% of global GDP.
- Food price inflation – In Developed Markets food is 17 per cent of global household expenditure but in Emerging Markets it is 40 per cent. Russia and Ukraine were 32 per cent of global grain production. It was widely believed that the West could make up this short fall but with the announcement that France, one of the world’s largest wheat producers, is in drought and India with their heat wave having banned exports of wheat, many are speculating that wheat production ex Russia and Ukraine will be down 15-20 per cent, therefore food price inflation pressures will increase.
WHAT DOES THIS MEAN FOR PORTFOLIO CONSTRUCTION?
Investors need to focus a portfolio on preserving purchasing power to inflation. In other words, seek investments with a correlation to inflation or which react positively to an inflationary environment.
The first one is easy, as Martin Gilbert the Chairman of Revolut posited, we are at an end of the 42-year bull market in bonds. He doesn’t see merit in owning many bonds.
The challenge is not necessarily one of asset allocation but rather of ensuring the right balance within asset classes, especially equities, and the need to restructure portfolios to cope with the future. You may need to lock in some losses and deal with the psychological issue of what to sell to rebalance an asset class.
Equities will be volatile but nevertheless should serve as long duration assets. Having said that, following are some key areas to take into consideration.
- Exposure – Look at your exposure to value and quality as they deliver tangible assets and cashflows.
- Technology – There has been much negative talk about technology. Interestingly more than 50 per cent of the selloff in the US S&P500 has come from seven companies (and they have large weightings, five stocks alone making up more than 20 per cent of the index).
- Local equities – Australian equities, in addition to those of Canada and Latin America, are markets where you need to ensure you have exposure, due to all being commodity exporters including energy.
- Lower quintile – Japan and China stand out as both are now at bottom quintile in valuations and there was some discussion at Fund Forum that China will be like the Germany of the1970s in terms of its growth.
- Asset classes – consider Real Property and Infrastructure.
- Commodities – should be included in portfolios either directly or through commodity shares due to their correlation with inflation.
The reality is that you can price in inflation and interest rates but not geopolitical events. There is always going to be some level of uncertainty and cyclical change. You could argue that now is an interesting long-term entry point for equities.
Mean reversion has occurred but equities rarely trade at their mean. Just as they traded above their mean, they can and probably will trade below it due to an overreaction to geopolitical events.
Our final thought is that we are at the end of the era of central bank benevolence. This is a major regime change for investors. As with all such market upheaval, the circumstances throw up both risk and opportunity, making careful planning and rebalancing vital