Just as the recent decade has seen solid returns across financial markets, the beginning of this year has been one of the most difficult starts in recent history. A correction had to be expected; but the speed and ferocity across markets has been more dramatic than usual. Equities have fallen and the Nasdaq index entered a bear market, with the index declining more than 20% and many stocks being down more than 50%. In fixed income, the relative drama has been even larger. US, Euro and CHF government bonds have seen their worst 18-month period for more than two decades. As seen in Figure 1, USD investment grade corporate credits faced a drawdown of 20% and losses in the index ETF LQD have reached 15%, year to date. Long duration treasuries have lost almost a third of their value in 18 months. Short-term cyclical risk has increased on the back of Putin’s aggression and brutality and the Chinese government’s preference for lockdowns (which are no longer to be criticised according to the Politburo, cited in Bloomberg on May the 6th). Both phenomena add uncertainty and inflationary pressure at a time where the Fed is hiking into a decelerating economy.
From a strategic and long-term point of view, we think global markets are now in a better position than 4-5 months ago and we expect that stability will return when it becomes clear what is needed and what monetary tightening will be implemented both in the US and Europe. Bond yields have increased across the western world and both Italian and US 10-year yields moved above 3%, which in the latter case means they are also close to their average over the past 20 years (see Figure 2).
Figure 1. Significant losses across the fixed income universe as the Fed resets interest rates
This is an advantage for multi asset portfolios as higher yields increase the probability of higher aggregate returns. For dynamic allocation strategies, such as those we cover in this publication, it has the associated benefit that bonds can now be expected to deliver positive returns in a larger range of scenarios, including better returns, should we face a crisis or recession; a scenario for which the odds have increased (we will return to this and update long-term return expectations in the main text).
The Fed should also be more helpful in the future. After losing its way last year, it has now laid out plans for a normalisation of monetary policy and a resetting of interest rates, moving “expeditiously” to a neutral rate of approximately 2.5%. The statement and press conference in early May made it clear that the Fed intends to tighten by 50bps, at a number of meetings, while at the same time scaling back bond holdings. Powell went to great length to assure that the Fed will tighten enough to bring inflation down. With yields up significantly, and markets expecting the Fed Fund rate to peak above 3% next year, we think that delivering on these expectations will be enough to tame inflation, as policy is set to be much tighter in 2022 and 2023 than in 2021.
The dual tightening, with rates moving up and the balance sheet shrinking, takes away some of the risk of a long-term discrediting of the US monetary system and a self-fulfilling inflationary wage spiral. It also makes it less likely that the value of the USD and US government bonds will be undermined by inflation and money printing. More important for our positioning, it also increases the cyclical risk both in terms of valuation pressure and an increasing probability of a negative spiral between increasing bond yields, corporate bond spreads, declining economic growth, pressure on profits and declining asset values. It is therefore time to move to Defensive positions:
In our systematic equity allocation mandates and funds, we are reducing equity holdings from Balanced positions with 60%-70% equities to between 25% and zero, depending on the strategy. We are investing the proceeds mainly in relatively short duration government bonds.
Across our global fixed income opportunities portfolios, we are reducing our high yield positions from 60-70% to between 25% and zero, with the remaining part invested in high-grade bonds.
In our multi-asset strategies, we are reducing our positions from 30%-40% equities to between15% and zero, supplementing with high yield bonds and high-grade bonds.
The evolving world order
While the Fed and other Western central banks are trying to reset the clock on inflation and interest rates, Xi is trying to take China's relative positioning in the world back to the glorious days before the “century of humiliation”, as it is often referred to in China. In and around Russia, Putin is trying to establish an impression of greatness while referring to history (Was it a great life under Lenin, Stalin, or the Soviet Union?); or at least some respect for himself and his once KGB friends. Putin’s actions and incoherence has now reached a level where Scholz calls Putin’s efforts “disgraceful" and a “falsification of history”. More important for markets will be how China comes out of its re-instated lockdowns. Meanwhile, Xi is promising increased investments in education, infrastructure, and affordable housing. These aspirations are hard to disagree with, but also hard to deliver on in a big command economy. Therefore, the hope remains that China turns back towards a pragmatic Chinese version of capitalism. In the short-term, we urgently need evidence that investment activity is actually taking place. So, while Xi´s words are normally followed by action and progress in China, there are signs that this is less straight forward this time around. Conflicting messages from the top leaders, some of whom push for stimulus while others demand restraint and lockdowns adds to uncertainty and survey data is not very encouraging. The latest business confidence indicators in April and early May, from both the private and public sectors, show readings below 50, which anticipates decline rather than growth in the service
Figure 2: The Fed has pushed up yields and European government bond yields have followed
and manufacturing sectors. These readings are corroborated by company-specific reports during the US and European earnings season, pointing to increasing signs of renewed supply side disruptions around the Chinse transportation hubs, especially Shanghai.
Returning to the USD and the Fed, in recent years and decades we have seen discussions of the role of the USD and how it will decline in importance. Such ideas are very popular with large groups of people who are displeased by the dominating role of the US, but as of today there is no stable and appealing alternative. As the Fed has been preparing the world for interest rate hikes, the USD has increased in value and the Yen; the Euro, and the Chinese renminbi have lost out.
Figure 3: The Fed USD has re-gained strength as the Fed has moved ahead of ECB and PBoC up yields
The issues with the Yen and the Euro are well known and relatively stable. The problem with the Chinese currency is more controversial and dynamic. Growth prospects should be better for China than for other regions - ceteris paribus - which should lead to an increased standing in the global economy. But the timing is tricky, and it now seems that the current leadership is more interested in absolute control and unity rather than in solid growth. Gone are the days where being entrepreneurial in China was applauded and being rich was glorious. The latest message, as quoted on Bloomberg, is that the Politburo stands united in the “fight against any speech that distorts, questions or rejects our country’s Covid-control policy”. Maybe that is right, but when the leaders of a country start to dictate what the right opinion is on things like this, it is normally a sign of other issues brewing under the surface and also of a lack of control of declared policy goals. It therefore looks as though it is time to prepare for more rules and regulations from the top down, but not more global enthusiasm for a currency, which even the local population, whom these leaders declare to be serving, are not free to exchange or convert. All in all, very far from the somewhat arrogant statement from the then US Treasury Secretary, Connally, that the “USD is our currency, but your problem.” In the context of the early 1970, Connally’s statement contributed to a further decline in the USD that we do not expect this time. And it would probably hurt China and Europe more than their economies can stand at the moment.
We are therefore left with the USD and the US yield curve as the place where prices are set, and the cost of capital is determined, and here we have seen a very significant and decisive reset. The US 10-year yield is close to its highest level in 10 years, and just around the bottom of the range for the period before the great financial crises. European yields have followed the same direction and the days of zero interest rates are now over. In this context, and with the current inflation fears scarring market and consumers alike, it is essential that the Fed maintains control of inflationary expectations. As seen in Figure 4, the market implied inflation rate for the 5-year period, including the current level, is well above 3 percent, which reflects the current high levels of inflation and a gradual decline from now on.
Figure 4: US market implied inflation expectations 5-years & 5-year in 5 years
Future expectations, as reflected in the implied 5-year inflation rate 5 years from now, have moved up but remain within the range seen in the last 20 years. This is a period during which we have seen significant crises, but we have also experienced more significant progress in both growth and technology across developed and emerging markets alike. If the Fed can maintain this relative control of market pricing for inflation, it will be easier to guide current inflation downwards, maintain financial stability, and secure either a soft landing, or the second-best scenario of a short cyclical recession. Such a recession would probably create more short-term volatility but would also help ease pressure on the economy and help set the world up for a prolonged recovery, with a more balanced growth and with less excessive monetary, fiscal and health policy measures than we have seen in recent years.
For investors, the long-term outlook for monetary normalisation, increased credibility of the USD and US monetary policy, and the rising risk of a recession, all mean that again there is a reason to use both bonds and equities in investment portfolios. For our specific investment style, it also means that the future should offer more rewarding investment opportunities than in the last 3 years. The reason being that our systematic approach works better with traditional boom-bust cycles than with “out of range” extreme events like pandemics, trillion-dollar stimulus packages and excessive money printing. We are not arguing that one should expect the world to return to its previous normal. Such a state may never have existed and should not be expected anytime soon. What we are saying is that if we return to a world of “normal excesses”, we can expect average returns for the next 120 years such as those we have seen over the last 120. For a shorter time-horizon, such as 10-20 years, returns will depend on current market pricing and on other conditions of the financial environment, what we often call “Capital Market Assumptions" (CMA’s) when modelling them for individual asset classes for the future.
Table A: Historical asset class vol. and return in USD and Capital Market Assumptions
In the current state of “normalising extremes”, such assumptions could be formulated as average returns for equities and returns for fixed income close to current yields. For the latter, this would mean that we assume that roll down on government bonds compensate for losses from further yield increases as and if we see more drift up in yields. Defaults in high yield markets are expected to be compensated by moderate positive roll down in yield’s, combined with a very gradual and limited spread tightening. In numerical terms, this could be expressed as the return and volatility assumption shown in the last column of Table A.
Figure 5: Expected (Mean) cumulative return for a 60%/40% portfolio (with 5% percentile bands)
Obviously, the exact portfolio construction can be questioned. Many would argue that it misses corporate investment grade credit (which is normal to include, but which is down 16% year to date)
Figure 6: Expected (Mean) cumulative return for a 40%/60% portfolio (with 5% percentile bands)
and hedge funds, but this is unlikely to change the overall picture and conclusion; that is to say, while investing in a Balanced portfolio for 20 years, decent returns can be expected. Specifically, in this case, holding 60% equities and 40% bonds, the mean expected return is 246%. With the same investment assumptions, but with a portfolio of 40% equities and 60% bonds, the return should be expected to be more like what we show in Figure 6, namely 136%. The reason for the large difference is the effect of accumulating interest on cumulative returns. The simple point we wish to make is that an investor holding on average a portfolio with 60% equities rather than with 40%, obtains a substantially higher return. If by using our dynamic investment style with the focus on bringing down maximum drawdowns during recessions, one can convince an investor to hold an average of 60% equities instead of a traditional 40% allocation, this should lead to approximately 100% more return over the next 20 years. This return does not depend on outperformance from our process or a belief that the dynamic allocation process will create a superior return over time relative to a static portfolio, it simply derives from the comfort that the process provides and which, in turn, allows an investor to hold more equities on average.
Mads N. S. Pedersen
Managing Partner and CIO