How markets will deal with inflation and rate hikes
2021 was a good year for equities, but a bad year for US government bonds, which lost money. As we remained “Risk On” throughout the full year, it was a very good year for our mandates and funds, which all outperformed their benchmarks by several percentage points and delivered solid absolute returns across all currencies. Our flagship fund, ACCI Systematic Allocation has delivered a return of 43% over the last 18 months, 19% through 2021, and 6% over the last 3 months of the year. It thereby outperformed its Bloomberg and Morningstar peer groups with 12% and ended in top 5% of the Bloomberg peer group. The underlying Dynamic Allocation Strategies have now delivered positive returns for each of the seven years since we introduced the first version in 2015. Seen in hindsight, 2021 could seem like an easy year. This however masks the fact that the Fed in their push for an all-inclusive supercharged recovery helped create such a strong boom in jobs and demand that it lost control of inflation, which came in more than twice as high as its target and its expectations at the beginning of the year. In China, the authorities have been forceful in their realignment of the interests of the Party, the People, and the Corporate Sector. As a result, the economy slowed and MSCI China lost money index and severe losses across much of the Chinese USD denominated high yield bond universe.
While the backdrop is scary, conditions in fact remains supportive, as captured in our algorithms and reflected in our positioning. The main drivers are the ongoing corporate profit boom, driven by solid macro variables from corporate confidence to US retail sales and still low borrowing costs in the corporate credit market. In the US, companies have managed to capture the positive effects of increasing demand and low financing costs. As a result, earnings of the S&P 500 companies increased by more than 42% year on year through Q321 (the latest quarter we have data for). The S&P 500 index returned more than 25% in 2021 and more than 100% the last five years.
Figure 1. The Euro/USD has moved a lot, but changed very little since the euro was introduced
The other big asset class for the US middles class, private houses, went up more than 20%. These dynamics are very positive for the economic outlook as wealthy employed consumers will spend and keep the economy strong. They are also a reflection of the main problem we face at the start of 2022, namely, inflation and the associated fact that central banks talked about equality, but fuelled inequality, both via asset prices and by allowing inflation to accelerate well above income growth for the people whom they claim to be intending to help. We don’t think that there has been intentional harm. Rather, it seems as though central banks became complacent and filled with their own newly found ideals. In any case, it has led to a situation in which the Fed plans to tighten gradually into a decelerating economy and where government bond investors have lost about one year of yields in one week. This is positive in comparison with a situation in which global central banks would accept full responsibility and hike rates to be sure to get inflation down to their target levels within their targeted time horizon. Neither we nor the markets expect any such “recognition”, because it would create a new recession and no central bank has any incentive to admit failure when the situation can be interpreted as an unfortunate series of unfortunate events, such as bottlenecks after a pandemic and inflation after money printing.
For the time being, markets have assumed the tightening path and are now reflecting an expectation that the Fed will hike in March rather than in May. This has added support to the USD, which continues to be the world’s reserve currency. Not least, because anything that undermines faith in the USD seems to be worse in Europe, Japan, and China. For investors, this also implies that any risk asset sell-off should still be expected to lead to a stronger USD vs the Euro. We therefore remain hedged in our USD and CHF portfolios while we have significant, but not dominating open positions in Euro USD in our Euro portfolios. Related to this, please note that last year move of the USD against the Euro (and the expectations of financial sector strategists) hardly registers as a movement on a 20-year chart.
We maintain a 100% equity allocation (40% overweight) in our Systematic Equity Allocation strategy and the associated ACCI SA fund. As of the end of 2021 strategy was up 24% and the ACCI SA fund was up 19%. Outperforming its Morningstar benchmark with 11%. Our Euro growth mandate with up to 100% equities provided a 35% return through 2021, partly due to positions in US equities.
Across our global fixed income opportunities portfolios, we maintain our short duration, high credit risk positioning. Despite a small setback, these strategies are up 1% year to date and 2% year on year.
In our multi-asset strategies, we retain the full allocation to equities and the enhanced 30% allocation to high yield bonds. These portfolios delivered a return of 14% in 2021 with the corresponding ACCI Diversified fund up 14% year to date and our Euro mandates up 16-22% depending on risk level.
How will markets deal with inflation and rising rates
Counter to the negative implications of uncertainty and inflation as described above, current financial conditions are supportive for markets, as reflected in credit market dynamics and the momentum in the equity market. A strong consumption and investment boom supported by investments into a sustainable future is dominating the economic outlook and has led our algorithms to bottom out and again move upwards. As always, Europe is doing OK when the rest of the word is booming; and further support is expected from China where the government has decided to re-ignite growth with an easing of monetary policy. We therefore remain fully invested in equities and high yield bonds. Even so, only one or two more policy mistakes of the magnitude of 2021 would make sentiments change. We are therefore ready to reduce risk decisively as and when needed.
A key question for 2022 is how the Markets will deal with inflation and rate hikes. If anyone had been in doubt about its significance, the selloff in bonds on the back of the release of the FOMC minutes in the first full week of the New Year is a good reminder. The key message from those minutes was that the Fed will possibly have to hike rates faster than previously planned. Given that the FOMC never gets forecasts of its own actions right, this should not be seen as a big surprise. Still, it led to a sell-off in both bonds and equities. As seen in Figure 2, the US treasury yields are now significantly up since last year’s trough. As the US 10-year has only just reached 1.7%, the implication of the rates move is that a US 7-10-year duration government bund ETF lost about one year of yield in one week. We expect long duration bonds to remain a poor investment, especially on a risk adjusted basis, as yields trend up towards 2.5-3%. But it should be noted that equities do not necessarily decline when yields go up. A short-term sell-off when yields move up is a natural and even rational thing for equity markets, because equity “duration” is by nature very long.
Figure 2: US Government bonds yields since 2012
But in that sense, markets on aggregate are not rational in the medium and long run. This is partly because the hypothesis of market rationality is not very resilient to observable phenomena such as risk aversion, transaction costs and investment approaches dependent on tax considerations. Nor do efficient market hypotheses recognise the personal financial need to divide invested assets into different buckets, dependent on time and purpose. Such considerations play a very large role on individual and aggregate levels across markets and the world. This is the case both for long-term savings of HNW and UHNW individuals and for the growing part of the world population investing indirectly through pension funds.
In such set-ups, considerations are often delinked from short term risk and more influenced by longer term risk considerations such as the risk of not having real return in the long run (the real value of a pension). The above considerations could seem a bit remote, but they are behind the fact that while we hear many investment strategists declare at different times that there are no more buyers in the market or that the market needs a catalyst to move up, this is pure, good-intended nonsense. In normal months, the average pension fund will experience inflows which have to be invested and as it holds portfolios with target equity weights, some inflows will be allocated to equities. (During larger market moves and panics, we can see the opposite in the form of forced selling). From a more practical point of view, we also know that the US equity market has delivered solid return through most environments through the last 120 years. The same has been the case across the world the last 70 years (countries losing wars or turning into doctorships or autocracies are exemptions). More recently, buying the S&P 500 even at peak levels have delivered positive returns across decades. This holds true even if the timing was not ideal and purchases were made, for example, in the year in which the last tech bubble burst, or just before the great financial crisis.
Figure 3.USD Yield to Worst for US High Yield and US Investment Grade Bonds Edge Sustainable
As for the more recent Fed tightening, buying the S&P 500 just before the taper tantrum in 2013, holding for years and then selling when yields peaked in late 2018, would also have delivered a solid total return of 170%. Holding onto this position until today would only have increased these returns.
Returning to the broader context of market directions and the Fed and other western central banks, we don’t think they have any more appetite for the risk of a recession than they did in 2018 or 2020. This means that if markets collapse, they will stop tightening out of fear of a recession (even if such recessions will be unavoidable at some time). In the US, it would be an equity market collapse. In Europe, it would be more likely that the movement of spreads on government debt and sovereign bonds would scare the central banks away from tightening further. We think this fear is both realistic and reasonable. Italy and Spain cannot afford to pay “market rates” for their government bond debt and the Fed has enough bad publicity. They don`t want to be accused of causing a new recession.
Figure 4. The GFO Strategy VS the US Agg Bond index (ETF)
Should it prove necessary to scale back tightening as yields move too far up, it will probably be initially through dampening the expectations of rate hikes. After that, a resumption of Quantitative Easing is likely. Buying credit bonds and equities outright will probably be reserved for the eventual outright recession. Particularly now that this type of policy has been complicated by the scandal around market trading by FOMC members. For the time being, this scandal is probably more important for politicians and the Fed than for market. The final round of US Corporate Bond buying in the spring of 2020, however, does look increasingly suspicious, bearing in mind how much it benefited everyone around the then President Trump, as well as, apparently, FOMC members, including Fed Vice Chair Clarinda and other FOMC members, and how little it was needed for already strongly rallying markets. We prefer to assume that this was all simply misjudgement and the fear of missing out, but it will have a negative impact on the Fed’s freedom to act. That, however, will be when it is time to cut again. For the time being, the direction is towards tightening. Three to four hikes are now priced in for 2022 and we think this is as realistic as any forecast. When it comes to further movements, we would find it reasonable to use a base case of a hiking cycle towards a Fed fund rate that peeks at around 2.5%. This is the same level as in the previous cycle, but with the new inflation target it implies about 50bps less of real interest rate and is likely to lead to a peak in the 10-year yield of around 2.5-3% over the coming 18-24 months. What will matter most to market will be in which context the Fed hikes. If inflation comes down below 3%, everything will be easier to deal with for the Fed and for equity markets.
We do not intend to convey a high degree of confidence in the exact numbers when we present these expectations for rate hikes and levels. Rather, these forecasts serve to illustrate in which direction we are likely to see the outcome and to justify why we prefer short duration to long duration bonds. Any movement of the described magnitude will put ongoing pressure on long duration USD and Euro bonds.
As seen in Figure 3, US investment grade corporate credit currently has a yield to worst of about 2.5%. With a duration of 9-10years for broader indices, this does not offer much ability to absorb, let alone compensate for the duration driven volatility, uncertainty and, in our estimate, outright losses. With high yield default rates close to all-time highs and likely to remain below or around 1% for the next 12 months, we strongly prefer to receive the 4.5% yield for USD high yield bonds with around 4-years duration. Such a position served the Global Fixed Income Opportunities strategy well during the previous hiking cycle from 2015 to 2018 and it has served the strategy well in the last 18 months when the US aggregate has lost more than 4%.
Mads N. S. Pedersen, Managing Partner and CIO