The relief rally that started mid-October has continued through much of November, as equity markets grab onto the belief that the Fed will slow the rate of interest rate rises. Whilst true, the reasons behind a slowing of rate hikes have not kicked in yet: slowing economic growth and weakening labour markets.
If economic growth doesn’t slow and labour markets don’t weaken, then we struggle to see why the Federal Reserve will not continue on its current path. However, all indicators suggest the opposite, hence its difficult to see how economic growth can remain robust. This makes us nervous and has kept us under-weight equity exposure relative to peers and reference indices.
One market that has, yet again, come to the fore, is China. The Chinese leader, Xi Jinping, has truly amalgamated power into his own hands by ensuring a seven-member Politburo Standing Committee consisting of his closest allies. At the same time, losing zero-covid policies alongside protest as a result of its harshness, has resulted in a new rise in Covid-19 infections. The biggest concern is the poor vaccination rates and seemingly ineffective vaccines. However, rumours or hopes, of loosening restrictions and monetary support have resulted in a significant rally in Chinese stocks, which should come as no surprise given that many Chinese blue-chips and Hong Kong based conglomerates were trading at multiples not seen before in history.
Industrial metals and the energy complex generally depict an environment of declining demand. However, along with changing sentiment towards China and further rumours of loosening restrictions, many of the industrial metals rallied during November in the hopes of a resurgence in demand from China.
Precious metals also did very well as real rates turned down; i.e. nominal rates were lower whilst inflation expectations remained unchanged.
We retain significant gold and gold equities exposure given the current environment.
We reduced some of our hedges in October, which proved favourable as equity and credit markets rallied in November. High yield spreads compressed, and volatility fell, which were a negative headwind for these. We have very recently started to increase our protection again, following the weakness in November.
Our hedge fund exposure generally had a flat month, which was on a relative basis a drag on performance.
We remain cautious on property markets. Whilst we believe we are closer to the top of the interest rate cycle than the bottom, the pain of higher mortgage rates are only now starting to show up in the data. Indeed, the fall in house prices in the USA over the last three months is the worst since the 2009 global financial crises.
As for infrastructure, we remain optimistic on the outlook, especially renewable energy and digital infrastructure exposure. The long-term tailwinds are intact, and in some space, only getting stronger.
FIXED INCOME & CURRENCIES
The US yield curve has now inverted across almost all of the curve, indicating a recession is highly likely. On the other hand, spreads – the difference between the yield on government debt and credit – remains very much benign, indicating that capital markets believe stress in corporate bond markets is unlikely. The two are at odds. Whilst 2022 has been one of the worst years on record for government bonds, in contrast we think that 2023 could well end up being the opposite!
As for currencies, the USD remains at extreme levels. Whilst perhaps too early to say the Dollar has peaked, short-term technicals have definitely broken down and a continuation in the reversal of the trend is not unlikely. However, the fundamental arguments remain intact: the US offers more attractive yields than Europe or developed Asia (and China!), whilst growth and inflation differentials in the US are markedly better than in Europe or the UK. A consequence of a weakening US Dollar would be an increase in global liquidity and looser monetary conditions for the rest of the world – this would be very beneficial especially for Emerging Economies, which offer very attractive yields and indeed an area we are looking to add.
Central bankers globally continue to focus on inflation and in determining the right speed and duration for the current monetary tightening cycle. Financial conditions have tightened rapidly, and Jerome Powell suggested that the pace of tightening is likely to slow. Our internal models suggest inflation will come down materially in the months ahead. Money Supply growth, as measured by M2, has fallen back to its lowest level since 1995, whilst energy (WTI & Natural Gas [as measured by Henry Hub]) has fallen by more than 30% since it’s early-June highs. A tight labour market and the sticky-ness of the shelter component (OER) of CPI, we believe will give the Federal Reserve and other Central Bankers enough support to continue tightening, but the factor the Federal Reserve will likely start to focus on more and more, is indeed the labour market (unemployment) and economic growth.
Capital Markets on the other hand will likely start to focus more and more on economic growth – or the lack of it – as opposed to inflationary pressures. At the same time, most leading indicators as well as bond markets suggests a recession is on the horizon. We expect a deeper recession in the UK and Europe, but a soft landing in the US remains more likely. At the same time, the structural deflationary forces – poor demographics, rapidly increasing old-age dependency ratios and significant debt burdens – remain very much intact.
With this in mind, bonds are back! At this juncture, we believe that the risk-reward profile in fixed income markets is far more attractive than the risk-reward in equity markets!
Monthly Review – November 2022