Despite Putin’s disgraceful entry onto the world stage, we expect that the key drivers of market developments over the coming months and quarters will be the Fed’s attempt to engineer a soft landing and China’s reigniting the growth engines of its domestic economy. On both fronts, we have seen some tentative positive developments. On the following pages we will outline how we think a soft landing can be engineered and how we can monitor whether we are moving closer to such a “goldilocks” outcome. Regarding China, it is likely that the supercharged global recovery in 2021 helped China to avoid a recession as the Party pushed through a political re-alignment. Consequently, if the US and EMU economies decelerate as expected, then China will need to re-start the domestic growth engine soon in order to maintain momentum in the economy. This is in line with China’s goal to create a domestically driven economy which is tied to the ambition of being a global power. In the short term, it is also needed to reach the Communist Party’s growth ambitions for this year and next. In this context, Putin’s invasion of Ukraine is disgruntling for China since it pushes up food and fuel costs for its 1.4 billion population and highlights how dependent China is on imports of such essentials. As Chinese equity market went from a long gradual correction in 2021 to a more immediate collapse in March 2022, China realised that it is too early to turn its back on US capital markets and, even more importantly, that it is again time to embrace economic growth and capitalism with a Chinese face. In mid-March, the Financial Stability and Development Committee stated that “Continuing economic development is the first priority of the Chinese Communist party”, that the Chinese authorities will work with their American counterparts on a framework for Chinese companies to remain listed in the US etc.
Figure 1. US Mortgage bonds levels reflect a significant tightening of financial conditions
In the US, the FOMC has started to rebuild credibility by outlining the path towards a neutral and possibly even slightly contractionary policy. As shown in Figure 1, money again has a price, especially if you want to borrow for a long time. For most people in the US, this is only possible in the housing market, where the cost of a 30-year mortgage is now above the levels seen over the recent 10 years.
After a short period of Defensive positioning during the immanent risk of a financial meltdown, we have repurchased equities and high yield bonds and are holding “Balanced” positions in our funds. This positioning is supported by a still solid business cycle and improving momentum in our market indicators. In this situation, a global recession is not a highly likely outcome. Barring further shocks to markets, we could be moving back into larger equity and high yield positions soon. The last time we moved out of “Defensive” portfolios was in 2020 and this was followed by 18 months of outperformance. For the time being, we are positioned as follows:
In our systematic equity allocation fund, we are holding 70% equities supplemented with relatively short duration bonds. We note that while Q1 2022 was not ideal for the performance of ACCI SA, it could nevertheless reach its birthday with a growth of lose to USD 100m of AUM since its inception 3 years ago.
The ACCI SA fund was ranked in the top 25% for the first 3 years (late March) and finished 2021 in the top 5% despite the fund’s performance fee. To expand and improve our offering, a new share class of the ACCI SA fund is in preparation. This share class will have a higher minimum investment and will be available without a performance fee.
Across our global fixed income opportunities portfolios, we have re-established high yield positions with a 70% holding of US high yield bonds with normal and short duration respectively.
In our multi-asset strategies, we hold Balanced portfolios with equities supplemented with typically 20%-30% US high yield bonds, also here with significant weights in short duration bonds.
How inflation was created and how it can be controlled
In our view, the key drivers of investment returns in the coming months will be inflation, the Fed, and how China restarts the domestic growth engine. Corporate profits and growth will as always be important, but if inflation can be tamed, these factors should be supportive as well. Corporates live well with inflation, as long as it is not accelerating out of control (assuming Putin does not launch nuclear or chemical weapon attacks, which we still see a low probability). In addition to the usual link to central bank policy, there is now also the political aspect of inflation to be considered, since it has accelerated to levels where it affects the quality of life of the US and European middle class, the political stability and accountability of the Chinese government, and the calory intake of the poorest part of populations across much of Latin America, Africa and Asia.
More directly related to financial markets, Fed policy, government bond yields, budget deficits, and corporate bond borrowing and profitability will also be key components in achieving a soft landing. It is therefore worth looking closer at how inflation can be contained and controlled. In this regard, we are not thinking of the time where Volker got it down by hiking rates astronomically and creating two recessions. That was effective, but also very blunt and very unpleasant for markets and for most of the US population.
Figure 2: The Fed has pushed up bonds yields much faster than last time they tightened
To see how inflation can be tamed in a less brutal way, let us outline how we got to the current elevated level of inflation. For decades, western central banks were run by economists who seemed to not be able to create inflation and sometimes said it was entirely eliminated at the same time as feeding consecutive asset bubbles. In Greenspan`s famous case, he realised only too late that the model he had been using had a glitch, as he himself said after stepping down. When the pandemic accelerated and the recession hit in early 2020, we therefore started from a less than optimal point, with a widespread assumption that even if money was printed it would not lead to inflation (some believed in Modern Monetary Theory). This might have been true had a moderate amount of money been printed, but what followed was truly extraordinary. As the scale of the political response to the pandemic became apparent, the global economy shrunk, market declined at a rapid pace and policy responses included: dramatic action as follows:
- The Fed and other central banks cut rates back to record low levels and delivered record amounts of quantitative easing both in terms of speed and amounts (one move alone was USD 750bln).
- Politicians followed with record amounts of fiscal stimulus, which in the US quickly reached commitments of USD 2.000bln (two trillion).
- The Fed followed its first rounds of QE with unlimited QE, in the form of declared unlimited purchases of government bonds. Other forms of credit covering most economic and financial areas were included and even high yield bonds were included in programmes.
- The Fed’s response initially seemed a bit excessive and now looks questionable because at least three of the most senior Fed members were privately trading in the market. (They later resigned before a proper investigation was conducted and published).
- The world economy became partly paralysed by a series of lock downs restricting global travel and individual movement more than either the first or second world war.
- As budget deficits skyrocketed, record amounts of money were printed. The ECB introduced negative interest rates and the Bank of England suspended the market purchase of government bonds and sent money directly to the treasury (a very big set of NFT’s one could say).
- In the middle of this experimental policy, the Fed, the US treasury, and the ECB apparently took their eyes “off the ball”, stopped focusing on actual inflation and, instead, talked about their broader purpose in society and about the potential positive effects of running the economy hot. (As if less fortunate minorities or poor people in general have ever benefited from inflation and the potential for chaos it brings).
As the very hot and supercharged US and global recovery gained traction, inflation also gained speed and by the end of 2021 most developed countries were recording inflation of more than twice the level that their respective central banks were targeting and had themselves expected in their often-published forecasts.
Figure 3: US government bonds have lost more than 10%. Asian high yield more than 25%
To assess what is needed to bring down inflation, let’s try to walk back the actions taken and see how far we are in scaling back the excessive policy:
In terms of more conventional policy, the largest fiscal stimulus packages seem to be behind us and the pent-up demand from the lockdown period should be expected to be spent in the coming quarters. So, these two “artificial” demand drivers will disappear.
In the money and credit markets, the largest support of demand comes from low interest rates, but as shown in Figure 1, a 30-year mortgage is now as expensive as 10 years ago, so this will put a dampener on the very buoyant housing market. As for the situation of government bonds, Figure 2 shows that yields have increased almost as fast as they dropped before the pandemic and in the early weeks and months after it started. As the Fed has woken up to its mandate and has started to talk about 50bps hikes, this has been priced into the market and yield increases have accelerated. This has led significant losses across fixed income markets. The broad USD market in the form of the US Aggregate index as expressed in a traditional ETF, has lost 10% over the recent 18 months. With a negative return of 2% last year and 7% year to date in 2022. Corporate investment grade credit bonds with relatively good credit rating but long duration have on average lost close to 15%, of which more than 10% are losses this year alone (the LQD ETF). US medium duration (7-10 years) government bond lost 2% last year and more than 8% year to date. Emerging market bonds have been the worst hit, in which the long duration USD denominated EMBI government bond index has lost 2% last year and 11% year to date, and the Asian high yield market generated a maximum drawdown of more than 30%.
While the losses are relatively manageable, the re-pricing of capital and the increasing borrowing costs will have an effect not least on final demand from consumers, particularly the real-estate obsessed US consumer, and on the capital structure optimizing US corporate sector, which is currently experiencing a profit boom that is driving investment.
From a top-down perspective, a further re-assuring development is illustrated in Figure 4 which shows that US money creation growth year over year, as defined by M2, has declined more or less as fast as it spiked. As the Fed continues to tighten it policy and soon turns from a buyer to a seller of government bonds, we also expect this number to decline back to below 10%. Although it is to be hoped that tightening does not take place to the same extent as in 2017-18, where the combination almost destroyed markets.
Figure 4: US M2 Growth has collapsed almost as fast as it spiked and is approaching normal
How to distinguish a hard from a soft landing
In summary, we are expecting European and US growth to decelerate from the supercharged levels of recent years to something more like trend as the stimulus runs off and rates are hiked. As a counterweight, we expect China to re-accelerate and we are seeing clear signs that companies across the world are behaving as usual and that they will invest in the coming months and quarters as their profits have increased dramatically in recent years.
Figure 5: Increased yields, relatively short duration and low defaults makes US high yield attractive
There are also reassuring and potentially positive developments that are less tangible, such as the reorientation of China towards economic growth through its local brand of capitalism; and a renewal of the ambition of the Fed and its Chairman to meet the price stability mandate. Assuming they don’t overdo their populist rhetoric and hike in desperation to get inflation down unnecessarily fast, growth can be maintained as it was after second world war (a large global chock like the pandemic). As the stimulus runs off, growth in the monetary base decelerates, QE is reversed, and the recent spikes in rates take effect over the coming 12-24 months, inflation should trend down towards 2%-3%, a level with which most people should be comfortable after the recent spike. The previous goal of inflation at or below 2% (the Fed and ECB) makes very little sense anyway because it is too rigid for a region such as the Eurozone in need of reforms and restructuring. Something more like 2%-3% would also serve the corporate world’s need for reasonable price stability and predictability of costs and revenues. It would also facilitate an ongoing transition of society to the introduction of new technologies. (This point is well described by Obstfeld and Rogoff in their article, Exchange Rate Dynamics Redux, Journal of Political Economy 1995 and in Chapter 10 of their book Foundations of International Macro Economics).
In a scenario as explained above, high yield bonds with a yield to maturity close to 6% and duration of 3-5 years should perform well. That certainly look more attractive than government bonds with 2%-3% yield and 4–10-year duration or corporate investment grade bonds with a yield around 3.5%-4% and a duration above 8 years. We therefore hold such high yield bonds in ACCI Diversified and ACCI GFO. As the Fed has proved to be less capable and less predictable than usual, we are holding a larger than usual part of these high yield bonds in the “short duration” segment with around 2-years duration. The best way to see if the economy is heading for a hard landing will probably be via spreads on mortgage bonds and corporate credit. If these spreads widen substantially, it will take down both housing and equity market and the economy will land very hard. In such a case treasury bond should perform well and we will be increasing our allocations to these should such a scenario unfold.
Mads N. S. Pedersen, Managing Partner and CIO