This month has seen banks and bank failures dominate the headlines and dictate the movement in asset classes.
Bailing out banks creates a troublesome moral hazard however without these bailouts’ equites would be lower and bonds will have rallied more aggressively.
At the end of February, we went underweight Australian equities against strategic benchmarks. This call along with establishing a position in government bonds in December last year and moving Developed Market equities to 65 per cent hedged in October last year have protected portfolios well.
We will discuss government bonds in more detail below, but the sale of Credit Suisse (CS) needs more discussion as it dominated monthly asset price valuations.
It is not the sale of CS to UBS that we need to discuss but the implications of what has occurred in the case of bank stress around CS and in the United States with both Silicon Valley Bank and First Republic Bank creating an old-fashioned bank run.
When you look back at the optimism some had towards markets in January the CS and US regional banking issues have seen that optimism evaporate and a rerating of sentiment to bearish levels.
As Capital Economics in London explain, “more problems may yet arise at other commercial banks in the US. But the industry there doesn’t have a worryingly high uninsured deposit ratio or unrealised losses on held to maturity securities in excess of capital. And if more skeletons do emerge from the closet, this is more likely to be the case for banks that have been relatively lightly regulated because they pose less of a risk to the economy.”
There is a central cause and especially in the case of CS that is leverage and the effect of this leverage in a higher interest rate environment. You combine this with liability management and reputation as the bank to take on risk that other banks would not look at, leading to questions over management and strategy as well as risk oversight.
We have seen a lot of talk around central banks pausing on their path to higher interest rates with many forecasters stepping back and suggesting we are soon to reach the peak in rates.
As Capital Economics point out, “so long as things don’t spiral out of control, the Fed might welcome some tightening of financial conditions, which it has been struggling to achieve by interest rates.”
Source: Heuristic Investment Systems
Whilst we enter the second quarter cautiously we do believe extreme pessimism is starting to take hold and the 3,200 level we previously saw on the US S&P 500 we see as a low probability (red box as per above). We advocate towards the grey box above with a thirty percent probability of a moderate decline in inflation, leading to 10 per cent downside in equities in the short term and a bounce of that degree in the second half of this calendar year.
The fact that we present six scenarios highlights the uncertainty and the need to remain flexible and change course if necessary.
The reason for our caution centres around the combination of an inverted yield curve, US manufacturing PMIs below 50, tightening lending standards (effectively a rate hike), rising unemployment levels (we acknowledge from an extremely low level) and what we have been discussing for several months, downward revision of forward earnings.
As we close out the quarter our tactical asset allocation against strategic benchmarks reflects this caution and is as follows:
Equities
Markets have been fixated on inflation data since it became apparent it was not transitory in early 2022, and this remained the case at the start of the quarter, with most equity markets rallying as core US inflation continued to print lower and at annualised rates of approximately 3% in December and January. China’s reopening helped lift global growth momentum during the quarter and talk of a pivot by the US fed gained momentum until strong US employment data and a lessoning in the downshift in inflation changed the narrative and resulted in markets giving up most of their gains from earlier in the quarter to finish only moderately higher by the end of March.
Interest rate expectations shifted dramatically during March following news of Silicon Valley Bank and Credit Suisse troubles, with markets moving swiftly to price in only one more 25bpt hike by the Fed and then three cuts during 2023 and four more in 2024. There is a saying in markets that the Fed tightens until something breaks and markets have interpreted these bank failures as just that. These banking issues will dent confidence and lead to tighter financial conditions, however we think markets may have got a little ahead of themselves and we are not calling for interest rates cuts in the US until 2024.
We maintained our underweight Developed Market Equity and neutral Emerging Market Equity position for the duration of calendar quarter one and moved our Domestic Equity Market weighting from neutral to underweight at the end of February. The decision to fade the rally in our local equity market came about due to the relative 20% outperformance of Australian shares compared with currency hedged global shares at the end of January. Our domestic equity market structure is overweight banks and resources and underweight technology, and this supported the market over the past year, however we believe it will act as a headwind moving forward as Australia’s economic resilient growth raises the risk of higher and stickier wages growth and inflation, which will lead to higher interest rates for longer and put pressure on housing and the banking sector later this year.
Bonds
Australian and global government bonds were volatile with yields ending the quarter considerably lower than where they started, reflecting an increase in the value of bond portfolios. This movement can be attributed to the stress in global banking sector and the market confidence of inflation is returning to the 2.25-2.5% range.
In December 2022 we added exposure to government bonds. We are pleased to see these positions showing early returns for investors but most importantly a defensive ballast in portfolios in times of market stress.
Credit spreads widened in the wake of the stress in the banking sector. We remain cautious with a preference for higher credit quality with an underweight position in high yield credit. This caution is extended to private credit where we preference senior secured or first mortgage loans with quality asset backing and low leverage.
Property
Listed property (REITs) is one of the most interest rate sensitive parts of the market and this led to underperformance during 2022, as the rising cost of debt used to purchase properties and the weaker outlook for rental growth reduced the cashflows available to investors. The sector was mostly flat during calendar quarter one 2023, outperforming equities in January on optimism interest rates had peaked and then falling away towards the end of the quarter with banking fears leading to weaker growth assumptions and tighter credit conditions.
We have been reducing direct commercial property exposure where liquidity is available, as we expect weaker growth assumptions to act as a headwind to the sector later this year. Capital Economics highlight the high concentration of lending to the commercial property market by smaller US banks as a risk to the broader property market, as they believe smaller banks will be required to raise depositor rates to retain funding in this higher interest rate environment, which will require these banks to raise lending rates to maintain profits and ultimately lead to tighter financial conditions.
Alternative Assets
The valuation of unlisted assets remains a topic of debate and we have remained cautious investing in existing assets with valuation risk.
We continue to believe that distressed opportunities could present themselves in Property, Diversified Credit and Private Equity. Over the quarter we met with a number of Private Equity and Venture Capital secondaries funds managers however have not yet made an investment.
We are beginning to consider opportunities in direct real estate where the manager is in a position to act quickly and tactically deploy funds over the next 12-24 months. Given uncertain economic outlook and significant increase in the cost of capital opportunities to purchase quality assets at attractive prices should present themselves.
We remain positive on high quality private credit and infrastructure assets for which we increased our strategic allocation late last year.
Summary
We enter the second quarter of 2023 remaining cautious, underweight Australian and Global equity markets with the view that tighter financial conditions will lead to declining corporate earnings.
We have started to see some pessimism emerge which reminds us that sentiment can shift quickly and we must remain flexible pivot when necessary.
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