The continued transition to a better state of the world
2022 has been one of those painful years where most things in markets have gone the wrong way and where most assets have had negative returns. The feeling is only amplified by the fact that, in retrospect, 2021 seemed so much easier. Looking at the last 15 years of equity market history as shown in Figure 1 reminds us that markets had already started struggling in early 2021. Equities with exposure to China and Chinese consumers struggled along with those companies based on future earnings rather than current cash flows. As reflected in the Hang Seng China Enterprise and Nasdaq Dragon indices, some of the key initial triggers were a combination of challenging valuations and Chinese “power politics”. Remembering this helps us appreciate that the market normalisation and transition following the “excesses of the pandemic” has now been running for almost two years. It would take until the end of 2021 before Nasdaq rolled over, and only in early 2022 did S&P 500 reach its peaks for the cycle. It is difficult to say how much of a role the blow up in the Chinese real estate sector and the clamp down on Chinese IT companies played, but it is telling that this highly leveraged sector went into crisis as the price of the USD started climbing. What is in any case clear is that the bear market in everything has been driven by more than one factor, and that the tightening from the Fed and from Chinese policymakers had a significant role in the market correction. On the following pages, we will return to the topic from the opposite side of the question, namely, what it will take for markets to bottom and then commence a sustainable global recovery.
Figure 1: Global Equity Market Return over 15 years and through two recessions
Here is a short summary of the path we see through the current problems and the way that the painful transition will play out. As seen in Figure 4 below, US inflation has now rolled over on the four measures primarily tracked by the press and by the Fed. Powell himself used both the CPI and the PCE measures, as is the Fed’s tradition, in his speech on the topic in November and again at the FOMC press conference on the 14th of December. According to the expectations of the FOMC, this development is expected to continue and core PCE is now expected to be 2.1% in 2024. The challenge for markets is that the median expectations of the members of the FOMC are that they need to hike to 5.1% while GDP growth slows to 0.5% for the full year 2023, and unemployment goes up by almost a full percentage point. The Fed refrains from the “R” word, but the most likely way to get to such an outcome is via a recession. Along with very weak Chinese growth, this is probably what scared markets recently. However, as we will explain on the following pages, in our view, the risk return trade-off has improved substantially recently. Lower inflation in the US and Europe makes it less likely that a deep recession will be needed, and it makes it easier for the Fed to cut rates if the US does fall into recession. The end of the power transition in China, combined with very low growth numbers, has paved the way for aid to the construction sector and broader stimulus measures and, as shown by the recent easing of Covid measures, the Chinese government stands ready to change its policy as and when they see a need for such change. Supported by a strong signal from our algorithms, we expect markets to find their balance and therefore maintain positive positions in our strategies and funds.
In our dynamic allocation strategies, with up to 100% equities, we have increased our equity allocations to 80-100%, with a US overweight which to some extent is unhedged in Euro portfolios.
In our balanced multi-asset strategies, we have increased equity allocations to levels between of 50% and 70% and have maintained significant holdings of high yield bonds.
Across our Global Fixed Income Opportunities portfolios, we have significantly increased high yield positions. In the more defensive mandates, we have scaled down cash positions.
Expanding our Sustainable investment offering
Since setting up our asset management business in 2019, we have continuously upgraded our investment offering. The latest such move is the launch in November of our new UCITS fund, EDGE Sustainable Growth. This fund is designed to reduce pollution and the carbon footprint of global growth investors. We are measuring the pollution of our portfolio in CO2 emissions relative to USD revenue generation and have a target of reducing this by 40-50% relative to the MSCI World index. The CO2 measure is chosen because the reduction of greenhouse gases is of urgent importance and because there are no other uniformly reported pollution numbers. As and when better, broader and more detailed data is developed, we will expand the methodology. For the time being, we are supplementing the hard measure with the use of an aggregate ESG score of each company and ETF we invest in.
Figure 2: EDGE Suitable Growth vs. a 60%/40% benchmark and vs. MSCI World
To improve the risk return profile and enhance the comfort of our clients on the investment journey, we are using our Dynamic Allocation Process, changing the equity allocation from 100% equities to 60% and 20% equities as and when risk reductions are deemed beneficial in the face of high risk of financial market meltdowns. The allocation process is supported by our market risk algorithms and, when we reduce equities, we invest the proceeds in high grade bonds, thereby creating lower risk multi-asset portfolios with a (60%/40) equity/bond mix in “Balanced” position of the strategy and an equity/bond mix (20%/80%) in the defensive position. We maintain that the only investment topic on which there is agreement from Tokyo to Beijing, or from Berlin and Paris to Washington, is to build back better and to support a green transition. As global markets move on from the double whammy of the Covid crisis and the interest rate normalisation of recent years, we expect the fund’s portfolio of growth-oriented stocks with its overweight in technology and healthcare to be well positioned to capture the eventual upward movement in markets.
Figure 3: ESG compliant single name investment portfolios with specific Ethical profiles
To service the growing demand for company-specific views along both sustainable investment criteria and ethical aspects, we have developed our fixed income offering to also include single bond research views. In this offering, we analyse the individual companies and investment instruments and create rating and duration specific sub portfolios as illustrated in Figure 3. These buckets are used either as single bond portfolios with ethical criteria or as building blocks in Global Fixed Income Portfolios GFO), where we deploy Dynamic Allocation Portfolio process in the fixed income segment.
What the paths to recovery could look like
Corporate earnings have been under pressure for several quarters, and the first declines are now visible in the data. For example, S&P 500 consensus earnings expectations, as released by Refinitiv under the I/B/E/S data name, are now expected to be reported as -0.7% in Q4 2022, while Q12023 and Q22023 are expected by analysts to deliver and aggregate earnings growth of 2.1% and 0.5%, respectively. As the slowdown bites, a natural development would be to see further cuts of these earnings of a magnitude of 10%+ for the first quarters of 2023. This would be in line with a moderation and normalisation of earnings as they cede to the continued pressure from inputs, labour and financial costs. As the US economy is now 10% larger, in USD terms, than it was a year ago, it would also set the stage for a recovery above previous highs in earnings as the economy recovers and inflation moderates.
This brings us back to US inflation and the updated chart in Figure 4. These data have again been better than expected by forecasters. We expect this downtrend to continue. On the one hand, current inflation numbers are pushed up by housing and rental costs, which are a lagging indicator. On the other hand, we have seen a decline in M2 growth from more than 20% year over year to less than 3% while freight rates (like the Shanghai–LA container rates) have collapsed, used car prices are down and housing activity is moderating, all on the back of higher government and mortgage bond rates.
Figure 4: US Inflation has peaked for now, and probably for this cycle
This is not to say that from now on there will not be setbacks on the way to market progress. Market downside, and the probability of financial Armageddon, however, is significantly smaller now than a few months ago, in our opinion. Despite the ongoing slump in the UK and Eurozone economies, and the Fed’s and ECB’s continued appetite for rate hikes, confirmed by their words and actions on the 14th and 15th of December, longer dated government bond yields have now normalised and lately somewhat stabilised (see figure 5).
Figure 5: US and European government bond yields have paused their relentless rise
Current and recent market developments have been dictated by the central banks. Going forward the factors most affecting the outlook are the timing of when Chinese growth will bottom, when financial conditions will ease and when the US corporate sector can start looking beyond the downturn in margins and earnings. None of these developments can be predicted with certainty, but from our perspective and as signalled by our algorithms, things have improved. We thus expect the US economy to go through a soft landing or a mild recession in 2023. In order to see if this holds true, and to assess whether to expect an outperformance of equities and high yield bonds over cash and treasuries, we are watching developments in the following areas of markets and the global economy:
- Inflation has turned. This has vindicated that the turn in inflation expectations and a meltdown in the AAA rated part of the bond market is now less likely. Further restraint in inflation will be supportive for risk assets, particularly whilst a “seeing is believing” approach seems to be adapted by the Fed.
- China has moved through its painful power concentration and party renewal and in November launched a plan for economic support across the economy. More is needed and likely to be forthcoming.
- In December, the Chinese authorities made what looks like a U-turn on Covid policy and restrictions. If maintained, this is an example of a decisive policy change, whereby a policy serving domestic logic is reversed for the benefit of the Chinese economy and thus for the global economy. There is enormous potential from such policy reversals as there has been a large amount of bad economic decisions made over recent years.
- Rather than a forecast, a housing market correction is now an ongoing phenomenon across the world. This should ease the need for hiking and for tightening financial conditions. This is positive, but also an area where too tight a policy can spiral out of control.
- Financial conditions tightened fast through much of 2022. On a relative and, later, on an absolute basis, these conditions have now started to ease. As seen in Figure 5 above, US and European government bond yields have stopped their relentless and parallel rise. For the housing market, the small declines in rates will be helpful, but not likely to be decisive. They are more important for the corporate sector.
- Credit markets have opened again, corporate bond spreads have stopped widening and started tightening, easing USD funding conditions for corporate borrowers (see Figure 6 below).In parallel, our credit conditions algorithms have bottomed out and started to trend up.
Our algorithms indicate a broad-based improvement in both market conditions and the business cycle, which has not always been in place at earlier turning points, but which has strengthened in recent weeks. More hard data improvements and less fake confidence has nudged us towards a more constructive view and to increasing our equity and high yield allocations across portfolios and funds. While we are now positioned for a positive outcome, another scenario is a prolonged recession where the downturn spirals out of control. The most likely trigger for this negative scenario continues to be the Fed. We still can’t be sure that they realise the power of their policy and if they get it half as wrong in 2023 as in 2021, they could force the housing market and the whole economy to further decelerate and even stall. This latter and very negative scenario could be super-charged by an economic or financial accident like an Enron or a Lehman-style collapse, all events which would warrant a defensive strategy. Given the current rate levels, this would probably lead to a rally in longer dated bonds, since a collapse of the US equity market would end the threat of inflation.
Figure 6: USD High Yield and Investment Grade spreads over US treasury bonds
This year, high yield (despite its implied credit duration) has outperformed long and medium duration government bonds while often moving in the same direction as treasuries. Next year we expect this to revert to normal correlations, which means high yield is also likely to deliver positive performance during moderate increases in government bond yield levels. In this context, it is worth noting that both short duration and normal duration US high yield are offering yields of 7%-8% and that Euro denominated high yield bonds also offer yields above 7%. This asset class also benefits from a long-term improvement in ratings. The share of US high yield bonds rated BB (the highest rating category in HY) bottomed at 35% before the Great Financial Crisis and has since increased to above 50%.
Looking at our Dynamic Allocation Portfolios, we note that they limited drawdowns in 2015, 2019 and during the pandemic in 2020, across mandates and funds. Following the largest stimulus in living memory, we captured the recovery and outperformed balanced benchmarks significantly in 2021. As it became clear that inflation was spiralling out of control in 2022, the Fed and other central banks reacted with dramatic rate increases. In this environment, our strategies faced losses along with global bonds and equities and with the 60/40 benchmark. As we moved into defensive assets, there was no protection when bonds also declined in value. The two main reasons for our difficulties navigating market and limiting drawdowns in 2022 can be, with some simplification, summarised as: i) there was a large sell off in bonds, taking down equities as well; and ii) there was no arecession in the US to ease inflationary pressure and therefore no defensive or “safe haven” to shift into. As the bond bubble has now burst, we also expect the opportunity set and the performance of our strategies to return to normal.
Mads N. S. Pedersen
Managing Partner and CIO