Volatility Continues - The path to a 'non-hard' landing narrows

The distance between our two global outlook scenarios outlined in August—one where growth slows materially over coming quarters but recession is avoided, and the other where recession is not avoided—has narrowed. While inflation pressures have clearly ebbed, the persistence of ‘actual’ inflation far above target has again seen the world’s central banks guide future policy tighter than expected. And in the US’s case, this has been well ahead of the time when the impact of already sharp interest rate hikes could reasonably be assessed, given the usual ‘lags of policy’.

Together with renewed tension in the Russia/Ukraine war, rising worries about Europe’s energy security through the coming winter, and a flailing China property sector, fears of a global recession have mounted. Volatility has intensified, particularly in currency markets, and bond and equity returns have once again moved sharply weaker (together) during Q3. 

In this month’s article we highlight the near-term challenges ahead. We continue to believe a broad-based global recession can be avoided. But greater evidence is needed that actual inflation is on a downward path and ‘demand destruction’ is sufficient to ensure future inflation stays on that path. This will be required soon (in a matter of months, not quarters) to avoid a policy error and slipping into our second scenario where recession in 2023 is unavoidable. This month, we also argue that active management of portfolios remains key, even in times of elevated uncertainty.

“We have always understood that restoring price stability while achieving a soft landing would be very challenging. And we don't know. No one knows whether this process will lead to a recession or if so, how significant that recession would be.”

Jerome Powell

Chair, US Federal Reserve   

21 September 2022 

The past month has made our ‘soft-ish’ sub-trend landing harder to see

In August, we outlined what we believed to be the two most likely paths the world economy could embark on over the coming year. The first (the ‘less bad’ scenario) had elements of a ‘soft-ish’ landing then reflation in 2023, while the second involved a good dose of stagflation and recession (and clearly much more of a ‘bad’ scenario).

While we expected it could take a couple of months to garner clarity, two months on that clarity has proved elusive. Our prediction of ongoing elevated volatility has, however, proved to be correct. And with that, our confidence that we will ultimately land in the first ‘less bad’ scenario has been challenged, and the risk of slipping into scenario two has risen.

As a refresh, our scenarios were:

• The first scenario—Inflation is peaking now (with long-term inflation expectations well anchored), helping central banks avoid over-tightening. Policy rates can be lifted enough to drive much weaker growth but avoid setting in train a global recession. As ‘demand destruction’ unfolds, central banks will ‘tilt their tone’ to one that is less hawkish (but unlikely dovish). While the equity earnings outlook has yet to fully capture the growth correction, clarity that a recession can be avoided will see equities base and grind higher in coming quarters, bond yields peak, and credit spreads steady. 
• The second scenario—Despite evidence of easing upstream price pressures, current inflationary pressures continue to spiral upwards through economies, or do not ease as quickly as hoped this year, demanding more restrictive cash rates above the recent pricing for ‘below 4%’ in both the US and Australia. This scenario likely requires a recession (and a significant uplift in unemployment) to bring inflation lower quickly. In this scenario, equity markets correct deeper as earnings outlooks are cut more significantly than expected, bond yields rally as growth slows, and credit risk increases. 

The distance between these two global scenarios canvassed in August has narrowed. But let’s be clear, in the US (the origin of significant policy uncertainty and concern), inflation isn’t getting worse. It’s simply not getting better as fast as we would like it to. Inflation also appears to be on the cusp of a peak in Europe and the UK in September.

While it hasn’t shown up yet in the reported consumer price data, there is convincing evidence across ‘upstream’ indicators, such as commodity prices, port queues and delivery times, that inflation is on the cusp of trending lower. Indeed, freight rates on some routes, like Shanghai-Los Angeles, have recently halved from their highs.

We remain convinced inflation will fall noticeably in the US by year-end and will be much lower during the first half of next year in the UK, Europe, and Australia. While goods deflation is in train, we need some ‘demand destruction’ (especially in services) relatively urgently. We mostly need consumers to choose not to spend their generous excess savings. We also need jobs markets to stop tightening and to stabilise, a trend which, thankfully, now appears to be emerging. A rise in unemployment would be an important signal for central banks, helping them to avoid over-tightening and making a 2023 recession unavoidable.

“There’s strong evidence that an overtightening of US monetary policy is currently in place. That is, money in the US economy has already become ‘too tight’.”

Longview Economics, September 2022

“Never mind claims that we’re in a recession; the reality is that unemployment is still near a historic low, and other measures, like the number of job vacancies, suggest that the economy in general and the labour market in particular are still running very hot. And we won’t get inflation down to an acceptable rate until things cool off.”

Paul Krugman

Economist

There is a plethora of near-term challenges and uncertainties

But last month’s US inflation data, which didn’t improve as much as expected, reminds us that we are investing in a period of heightened uncertainty. Sure, the outlook is always uncertain. This is true, and it is why a well-designed, globally diversified portfolio, including traditional fixed income and equity assets—as well as unlisted alternatives—remains the best way to preserve long-term capital through the cycle.

Still, to a greater extent than usual, investors are being confronted with a number of near-term challenges that either question our central case scenario about falling inflation or heighten uncertainty about other aspects of the investment outlook:

• Sticky inflation due to rising services prices—Inflation in good prices, globally and in the US, is easing noticeably, helping overall inflation to ebb. But given immense post-pandemic, pent-up demand for services, services inflation is still rising in Q3. Unless consumer demand eases soon, this could slow the pace at which inflation improves. Key areas of price pressures include rent, transport services (travel), and education. 
• Fears of a wage-price spiral—Very low unemployment rates are fostering concerns of a wage-price spiral in key countries. Undoubtedly, this reflects strong demand due to prior policy overstimulation. But it also reflects workforce participation (labour supply) that has been slow to rebound post-pandemic, either across entire country workforces (the US) or in particular sectors (Australia). There is a variety of drivers, from health concerns, early retirement, and a higher leisure/work ratio desired post-pandemic. 
• European energy supplies under pressure—With Russia now partially shutting down its supply to Europe (40% of supply prior to the Russia/Ukraine war), this will create supply and pricing impacts across all energy markets. In Europe specifically, heavy industries are likely to become uneconomic and may shut down as electricity prices soar, raising the risk of negative economic growth and rising unemployment. 
• Intensification of Russia/Ukraine war—With Ukraine re-taking parts of its country from Russian forces, this has led to a more aggressive response from Moscow, including a decision to conscript an extra 300,000 troops to intensify its war efforts. Moreover, according to the media (Time.com), after a series of recent losses, “Putin issued an ambiguous yet ominous threat to use a nuclear weapon”. Notwithstanding anger from world leaders, this leaves the outlook both uncertain and volatile.
• China’s property stabilisation remains elusive—China is seeing its worst property downturn in recent history with new starts -50% and sales -30% in May-July from two years ago. The policy response has been modest so far. While UBS does not expect this to evolve into a debt crisis, BCA Research notes “an imminent rebound in home sales is unlikely”. Together with its pursuit of COVID-zero policies disrupting activity and supply chains, China’s uncertain outlook is weighing on investor confidence.
• Potentially ‘unhelpful’ fiscal support—Globally, governments are making moves to limit the impact of escalating energy prices, across the UK and Europe, but also very recently in Australia. For example, the new UK government announced the largest (debt-financed) fiscal package since 1972 (almost 13% of output). This was not well received by markets, given high inflation, sending the British pound sharply weaker. Most forecasters now expect higher rates to offset any positive growth impact.

There has been significant currency volatility (and USD strength) over the past month

In addition to these cyclical uncertainties, the investment environment is also confronting a number of likely structural changes, including the fading impacts of 30 years of hyper-globalisation (as the world rethinks who it wants to engage with), as well as the end of 80 years of relative geo-political calm (with multiple potential geo-political hotspots in play).

Together, these uncertainties have led to greater volatility over the past month, particularly in global currency markets. The US dollar has moved to historic highs, and a number of currencies, including the yen, euro and British pound, are at multi-decade (or record) lows against the US dollar, and have moved there in a relatively disorderly manner.

Reminiscent of Q2 this year, bond and equity markets once again have moved sharply weaker (together) following the (bear market) equity rally through mid-June to mid-August. While bond yields have registered new highs for the cycle, equity markets have broadly retraced to around their mid-June lows.

We remain broadly neutral risk (overweight bonds relative to equities)

• Looking ahead, there is a range of key developments which will impact our tactical investment decision through October and November (ahead of considering our 2023 outlook in December):
• China holds its key five-year People’s Congress in October, where President Xi Jinping is expected to secure an historic third leadership term. The Congress’s passing may hold significant implications for both China’s COVID-zero policy and the extent of stimulus used to support the economy, as well as China’s weak property sector.
• US data for September will be key to the interest rate outlook. In particular, markets will be looking for signs of a ‘less tight’ jobs market in the next non-farm payrolls release (7 October), as well as renewed signs of disinflation in the next inflation print (13 October). The next interest rate decision will also be announced on 2 November, where the US Federal Reserve’s (Fed) outlook will be key.
• The impact of Europe’s reduced energy supplies and sharply higher prices will be watched in regard to the outlook for European growth (and corporate earnings). Gazprom, Russia’s energy giant, has recently reduced supplies further, almost to zero, with Germany speculating that maintenance claims reflect Russian sabotage.
• Developments in the Russia/Ukraine war will also likely be key to investment confidence in the period ahead and whether the situation improves or deteriorates.

In this environment, it is difficult to have very high convictions with respect to any asset class and we, therefore, remain close to neutral in our tactical asset allocations (with a preference for tactical positioning within asset classes). 

As we noted last month, we recently increased our overweight to domestic equities relative to global equities (reflected by a greater underweight to Europe). We also took the opportunity to extend our recently more favourable view toward government bonds by moving modestly overweight. We remain overweight cash, funded by our underweight to credit, with the view to deploying to risk assets should conditions permit.

Active portfolio management remains key, even in uncertain times

Taking a longer-term view, the brutality of markets this year has unwound significant amounts of valuation risk built up over many years. That’s not to say that some further adjustment may not lie ahead – it’s just that a significant amount of the journey should now be behind us.

For investors holding cash out of the market (putting aside the unfortunate fact that it buys 7% less than it did a year ago), it’s likely time to consider putting some (but maybe not all) of that to work. Valuation excesses now appear less problematic. For those with already fully-deployed portfolios, heightened uncertainty suggests a patient approach before adding risk to portfolios. 

But that doesn’t mean there is nothing to do. Slower growth, higher inflation, higher interest rates, and persistent volatility, even if the exact quantum of that remains uncertain, leaves a laundry list of opportunities to explore.

At an overall portfolio level, it’s time to check asset allocations haven’t drifted too far from their long-term targets. Uncertainty and volatility should also be catch phrases for focusing on quality and resilience in portfolios. Diversifying across multiple themes (such as ageing, urbanisation, infrastructure, or decarbonisation) can help minimise future drawdown risk.

Within equities, should you have a more defensive sector tilt? This question is key, given slower growth may impact discretionary consumer sectors and housing more materially than healthcare or quality technology that offer attractive free cash flow yields. There should be a focus on ensuring limited style bias or stock concentration risk across equity managers. Some equity markets are more fairly priced than others, such as Australia, which looks relatively defensive given a weak Aussie dollar, less inflation risk, and a relatively more protected growth outlook.

Within fixed income, is it time to consider the higher yields now on offer, potentially adding modest additional duration to portfolios? In alternatives, there is likely more to do in building defensive positions (like real assets) and ensuring diversification across years and sectors in private equity (and a clear plan on how returning capital should be redeployed).

Active portfolio management remains just as key through periods of heightened near-term uncertainty, as at times when we perceive risks to be more ‘normal’.

IMPORTANT NOTE

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