This commentary follows a similar pattern to the whole of 2022. It is the story of stubbornly high inflation, aggressive central bank rate increases and worries about economic growth. Central banks have never raised rates faster over such a short space of time, as they have done this year. The result is global markets are under pressure.
Many market commentators had been predicting that inflation would already be falling fast and central bankers would be quickly returning to the halcyon days of low interest rates and easy money. We did not share that view and positioned portfolios accordingly. Last year, we believed inflation would prove harder to tame and would necessitate higher interest rates than the market was expecting.
Markets are now coming to terms with the fact that higher inflation and interest rates are likely to be around for a while, and this is being reflected in greater volatility and lower asset prices. We have been playing defence during these turbulent times.
From a UK perspective, this quarter has been particularly challenging. The focus on “Growth, Growth, Growth” has been interpreted by markets as “Borrow, Borrow, Borrow”. Without the basis of sound economic forecasts by the independent Office of Budgetary Responsibility (OBR), it looks like “shoot from the hip” policy.
UK government borrowing costs, as measured by gilt yields, have risen sharply. Sterling has fallen against all major currencies. Economists are forecasting an additional £80bn of bond sales to finance these tax cuts, which is forcing UK gilt prices down and borrowing costs up.
Sterling has fallen because the Bank of England (BoE) might have to turn back to quantitative easing (QE) at some point in the future, in order to control these rising bond yields. All of this will likely add to the current inflationary pressures in the UK.
As the quarter ended, the sudden fall in gilt prices, triggered panic selling by the large UK Defined Benefit Pension Schemes to raise liquidity in the face of extreme losses. These pension funds have been engaged in something called Liability Driven Investing (LDI).
Pension funds have essentially borrowed money to buy very large amounts of gilts in an attempt to hedge their long-term liabilities. As always, leveraging portfolios leads to magnified gains and losses.
As is normally the case, the losses come in a violent fashion, and at the worst possible time. The BoE had to step in to provide emergency liquidity by purchasing government bonds, which proved effective in stabilising the UK financial system.
At this point, it is pretty clear that Europe and the UK will be moving into recession in a short space of time and may already be in recession at the moment. The US economy is looking more robust, however, it is widely expected to move into recession over the course of 2023.
Recession is a scary word but it is important to highlight that this is an artificial recession. It is being triggered by the central banks, not by the usual credit cycle contraction. Therefore, consumers and corporates are entering this recession in relatively good financial health. Balance sheets are strong and the job market is still extremely robust.
Due to this artificial nature, whether this is a mild recession or a deeper one will heavily depend on what the central banks do with interest rates over the course of 2023. Once they signal they are more concerned about growth than inflation, they will pause the rate hiking cycle, and may look to start cutting rates in the future.
To reiterate, we expect they will only start cutting rates when they get the “all clear” that inflation is coming down to “acceptable” levels. This is why we are spending so much time analysing the outlook for inflation.
We do expect inflation to start to move down over the course of next year. When analysing the current inflation trends, we can see US inflation may have already peaked, and even started to decline. However, when analysing the UK data, it signals we may be reaching the peak of inflation over the coming few months.
Please note that I said “acceptable” levels, rather than the universal 2% inflation target. If things play out as we expect, the global economy will be meaningfully weakening before inflation falls back down to the 2% central bank target. Put another way, our base case “stagflation” scenario means central bankers will be forced to cut rates even as inflation is high, meaning inflation will stay above trend for the foreseeable future.
Looking at the market’s expectation of future inflation via the inflation swap market, we can see that inflation expectations have been consistently falling throughout this quarter. This is a positive sign.
This timing of the “Fed pivot” – the US central bank moving from raising rates to cutting rates – is the single most important factor we are considering at the moment.
With all this negative news, I would highlight one of the most important principles of investing:
The direction of economies is dictated by how economic events play out
The direction of the market is dictated by how economic events play out relative to what is expected and currently reflected in prices
Our view of rising inflation coupled with aggressive central bank rate hikes has been pretty consistent throughout the year. We have positioned portfolios accordingly throughout this period. Our strategy of maintaining high exposure to assets we believe are positively correlated to inflation is continuing to prove effective. Therefore, we have seen little reason to change portfolio positioning at this time, as this scenario is playing out as expected.
Despite the general downtrend in asset prices, there was a significant rally in equities midway through the quarter, as market participants wrongly assumed that central bank rate rises might be coming to an end. We used this “relief rally” to reduce exposure to riskier assets like equities at a very opportune time, shortly before markets fell again. In this environment, we have been playing a strong defence by using market volatility to our advantage to protect capital.
Technology and growth sectors have continued to fall more aggressively than the broader equity market. As part of our stagflation portfolio positioning, we have very little exposure to these areas because of the negative correlation to rising rates and high fundamental valuations.
In light of these recent market drawdowns, it is worth considering whether they are now starting to look attractive. When we look at the relative P/E of growth orientated equity sectors such as technology, consumer discretionary and communication services versus the more traditional value sectors like energy, financials and materials, we can see that growth stocks are still trading at a 17% valuation premium.
Jonathan Prout is CIO at The Private Investment Office
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.