We are experiencing the next stage of risk asset re-pricing after the relief rally that dominated the start of this quarter.
What is important is to separate the market from the economics. Markets always look ahead, and when sentiment is at its gloomiest, it will be the time to buy. That is still some time off, probably next calendar year, however it is important to remind readers of the opportunity that will eventually present itself.
The negative noise around a recession in the US and Europe is loud but we believe it is important to have a strategy, as we believe risk-based assets will be higher than current levels on a twelve month basis.
The Federal Reserve (“The Fed”) in the US has a delicate balancing act as they have to attempt to reduce inflation and at the same time try not to send the economy into a deep recession.
While bond market performance has been ugly over the last 12 months, being negative 10-15 per cent, we have avoided this by having virtually no duration in our client portfolios. There will however soon be a rare opportunity to expose portfolios to bond duration at a very attractive entry point for this asset class.
There will eventually also be an opportunity to increase exposure to equities. We stress the need to have a strategy and stick to it, as you will be rewarded through time.
Back to economics, The Fed and most other Global Central Banks are attempting to ensure that inflation does not become embedded, by raising interest rates sharply, while balancing the growing recessionary risk.
A recession in the US and Europe may prove to be unavoidable. The question is the depth. We feel it will be mild in the US but in the Europe and the UK it will likely be severe due to the supply side issues specific to that side of the world.
Interest rate increases are working and according to Capital Economics “the auto and housing sectors have been hardest hit so far in what is expected to be the most aggressive tightening cycle since the early 1980s.
Higher rates have had the greatest impact on overall spending in Australia and New Zealand so far, though aggressive policy tightening in the US and Canada has also started to weigh on spending”.
In the meantime, as assets re-price, the short-term outperformance is going to come from avoiding mistakes.
We have reduced exposure to residential construction within our property credit allocations during the quarter, as we further implement our “avoid mistakes” stance towards asset allocation and selection.
We do believe our tactical asset allocation will continue to be very active in the next quarter, before we sit back and wait for the opportunity to add to risk-based assets.
In reviewing asset class performance for the last quarter, you will note that at the end of each asset class we are highlighting our positioning towards each asset class.
EQUITIES
US equity performance during the quarter was almost perfectly symmetric, with gains during the first half of the quarter pushing the S&P500 nearly 14% higher to 4,305 points and then losses retracing all of this and more, to leave the index marginally lower at the end of September than where it commenced the quarter in July.
This rally commenced due to technical factors, with so much negative news having been priced into markets. Softer than anticipated US CPI data in August added fuel to the relief rally and a dovish off-the-cuff comment from US Federal Reserve chairman, Jerome Powell, suggested the Fed could pivot towards more accommodative monetary policy sooner rather than later, further extending gains.
The annual meeting of US Fed Governors in Jackson Hole Wyoming triggered the sharp reversal from mid-August, as Fed Governors firmly rebuked this market assumption and conveyed the message that interest rates will continue to increase until economic activity slows and that interest rates will need to remain higher for longer to win the battle on inflation.
US Central Bank commentary in recent weeks has included repeated comments about continuing to increase interest rates into “restrictive territory” and keeping rates there “for some time”, whilst also increasing their expectations for terminal rates to the high 4% range during 2023. This more aggressive language will keep pressure on risk-based assets as we enter quarter four, however we will be listening closely for any change in language, as Macquarie Securities Managing Director Viktor Shvets says, expect phrases like “we have done a lot of heavy lifting” and “monetary policy works with lags” to signal a peak in Central Bank hawkishness.
Australian and European equities closely tracked US market movements during the quarter, which is common during times of stress, where all risk asset correlations converge towards one.
We remain underweight Developed Market Equities and neutral Domestic and Emerging Market Equities as we enter quarter four.
FIXED INCOME
Last quarter we discussed the record-breaking drawdown in Australian Government bonds and further weakness has continued through to the end of this quarter, with the 10-year Australian Government yield pushing back through 4%.
UK Government Bonds or Gilts registered their largest one day sell off in over 30 years in late September following a government policy announcement that included tax cuts and economic stimulus measures during a time of high inflation. Markets swiftly moved to price in an additional 200bpt of emergency rate hikes by the Bank of England and the Sterling dropped 5% at one stage, reaching record lows against the US dollar. 10-year UK Gilts pushed through 4.5% during September, which is a remarkable turnaround from the lows reached in August 2020 of just 0.065% and translates to capital losses of approximately 30%, per below.
These types of market reactions reflect the continued reduction in liquidity in markets. Former Future Fund chief Mark Burgess notes the importance of monitoring for “risks to the financial plumbing” of markets as increased volatility looks set to remain through to the end of this year.
Markets have moved to fully price a recession in the US. Capital Economics notes that the current tightening cycle is the most aggressive in three decades and has led them to downgrade several economic forecasts, with their base case scenario now anticipating a global recession. These forecasts increase corporate default risk, and we continue to favour well capitalised senior ranking corporate debt over higher yielding subordinated options.
We remain neutral fixed income as we enter quarter 4.
PROPERTY
The falls in domestic residential property accelerated during quarter three, with price falls approaching 6% on a peak to trough basis. Most market commentators are predicting peak to trough falls of between 15 to 20%, which will reverse the gains experienced since COVID. Direct unlisted commercial and retail asset valuations are yet to price in any economic weakness, as a chasm has appeared between bid and offer prices, with vendors stubbornly hanging onto price expectations from peak market times during 2021. Listed property REITs on the contrary have responded to the weaker economic outlook and the lift in real bond yields will continue to undermine REITs in the short term.
We remain neutral Property as we enter quarter 4.
PRIVATE EQUITY
We observed further provisioning within early-stage venture and growth stage Private Equity, as managers looked to more appropriately reflect the value of their private company holdings, given the repricing that has occurred in listed equity markets.
We continue to hear anecdotal evidence from managers that a wide gap persists between bid and offer prices for more established Private Equity businesses. Tighter funding costs, a weak IPO market and transaction hesitancy will eventually see prices adjust and we are currently evaluating several IPO secondary opportunities that will look to capitalise on these trends moving forward.
We remain neutral Private Equity as we enter quarter 4.
DIVERSIFIED CREDIT
We reduced our exposure to property finance during the quarter, as the Australian construction sector has faced significant cost inflation, whilst higher borrowing costs and pressure on the end value of completed projects has increased risk. In this environment we believe it is prudent to take a more conservative approach.
We remain neutral Credit as we enter quarter 4, preferencing high quality liquid credit over illiquid Private Credit.
SUMMARY
We have always talked about the need to remain diversified to ensure that in times of market stress your portfolio “bends but doesn’t break”.
There is also a lot of discussion around the bond market- equity market correlation, and how to position these asset classes.
We have the approach of clearly defining alternative asset investments that we do allocate towards to ensure an appropriate weighting to each throughout the cycle. This has assisted our portfolios in risk reduction and return enhancement.
Diversification does and will continue to make sense and provide rewards as we navigate this environment.
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