We were quoted in the press recently, saying that either late this year or early next year a once in a decade opportunity will exist for investing in risk-based assets.
We want to explain why we believe this and also why we believe the time to purchase these assets is not just yet, as we are not believers in “buying the dip” at the present time.
Whilst the negative performance of equity markets has made the headlines and nightly news, what many do not realise is that global bonds have experienced their worst period in history and Australian bonds their second worst period in history.
This has tested traditional portfolio construction theory. Whilst our portfolios did not hold duration, and therefore we escaped the bond market downside, bonds have traditionally acted as a defensive mechanism. In other words, they have normally rallied when equity markets have been under stress. This did not occur this time but, with 10-year bonds having briefly traded above 4.0 per cent last month, we will now be looking for an opportunity to add duration or bond market exposure to our portfolios when we believe the time is right.
INFLATION AND INTEREST RATES
Earlier this year we continued to believe that inflation would be transitory. We were wrong. It is systemic. Whilst core goods and shelter costs in the US are starting to fall and it looks like inflation is at or near its peak, it will settle at a level above the traditional 2-3 per cent range which has previously given the markets comfort.
Australia is lagging the US. Inflation here will not peak until later this calendar year.
Last month we mentioned to be careful not to get too caught up in all the negativity. It is important to sit back and put everything into perspective, to take a “chill pill”.
Many were calling cash rates in Australia to rise above 4 per cent but, as we mentioned, the speed or degree of the increase in the cash rate has little bearing on where it will end up.
Fixed income markets are pricing in a 2.60 per cent cash rate in Australia and 3.25 per cent in the United States by the end of 2022. This is why bond markets are pausing, as a lower peak in the cash rate than previously expected is now being priced in.
If inflationary data over coming months leads to a renewed bond sell off, we will be looking to add duration through government bonds to portfolios for the first time in years.
GROWTH (OR LACK OF)
The “R” word, or recession, also needs to be discussed.
Capital Economics in London said just last week that “the outlook for the world economy has darkened again and we have reduced our forecasts for all major economies, leaving them further below the consensus of economists. We now anticipate recessions in the euro-zone and the UK and expect the US, Canada and Australia to avoid economic contraction only narrowly. If a technical “global recession” is avoided, this will be largely thanks to a moderate post-COVID rebound in China and relative economic strength among the major commodities producers”.
JP Morgan Asset Management concurs, and a US recession is not the base case. Much of Europe, the UK and New Zealand are most probably already in recession and future GDP prints will surely make this official.
As we have often said, equity markets look ahead. Whilst it was announced last month that inflation had reached 9.1 per cent in the US, equity markets barely reacted. They are becoming immune to inflation.
Whilst the MSCI World index at time of writing is down approximately 28 per cent from its high, to put this fall in perspective during the GFC it was down approximately 60 per cent and in 1990/1991 it was down 25 per cent.
Equities do seem to be rebounding at the moment, led by technology stocks. We see this as a relief rally, following the strong sell off on the back of inflationary impacts of the war in Ukraine and the economic shocks in Europe.
We do think a further fall in the equity market is likely, on the back of a lack of growth. This will be driven by earnings revisions downwards, on the back of slower economic conditions. This will also support our position to add duration through government bonds back into portfolios. Duration becomes your friend when high interest rates impact the real economy.
What is not being discussed widely yet is that at some point – Capital Economics thinks this will be in mid-2023 in Australia – central banks will start cutting interest rates. Once central banks are perceived to have stopped tightening then we will support risk-based assets, in particular equities.
ONCE IN A DECADE OPPORTUNITY
As we said at the beginning of this piece, a great opportunity will approach for risk-based assets. Patience is important for investing and the next opportunity will be important for long term portfolios.
In the meantime, remain well diversified. Our clients will appreciate that it has been an unusually active year for our tactical asset allocation calls but, importantly, our portfolios have bent but not broken.
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