Most financial observers and investors will reluctantly agree: they face a multi-varied gauntlet of imponderable challenges. Sequential developments have ushered in monumental impacts upon capital markets. For investors, there have been few places to hide in 2022.
Firstly, an unheralded pandemic erupted; immediately injecting significant volatility into global economic conditions. At the outset, sales to house-bound consumers boomed. Then, when the pandemic began to recede, another set of economic sectors took the wheel. Businesses were quick to seize new opportunities; significantly boosting profits. These shifts were massive and rapid. Remarkably, only 18 months later, winning sectors had become losers. Huge swings in demand took place, laterally triggering both shortages and over-stocking.
This is not a typical business cycle…far from it. It is a difficult environment; one that breeds inflationary pressures. Scarcity fears have flamed additional inflationary worries.
One factor that played a noted new role was corporate pricing power. Though revenues may have declined or flat-lined, profits did not. This supported GDP growth, but unfortunately also contributed to inflation pressures. These profit-related factors were in part attributable to growing industry concentration globally.
The pandemic emerged at a time when interest rates were already low worldwide. Given the deep economic declines that occurred due to COVID lockdowns, stimulus expenditures skyrocketed and interest rates were reduced even further. These represented extreme policies that were considered to be irreversible at that time due to financial and economic fragility. Any attempts to unwind these stimulative conditions, it was believed, would trigger volatility and deep economic pain. To some surprise, the U.S. Federal Reserve took a tough stance once it become clear that corporate and societal opportunism boosted inflation to the highest levels in decades.
It remains to be seen whether a disinflationary environment will reassert itself again in the future once monetary tightening has receded. Indeed, left to fundamental GDP growth and natural interest rate trajectories, this disinflation should be the logical outcome. However, we expect that policymakers will promote higher economic growth through liberal fiscal operations.
Also to consider, is that non-economic factors will contribute to higher economic growth – at least for a time. Here we point to climate change-related infrastructure expenditures (estimated at more than $1 trillion per year to 2030). Societal preferences dominate here, not so much priorities of profitability and productivity — the traditional handmaidens of capitalism.
At a later point, however, we expect a form of stagflation to emerge. In such an environment, real interest rate levels will remain low. Also, inflation can be expected to bubble along (with some volatility) in the 3% to 5% range.
In the meantime, investors have hidden themselves under the rocks. Monetary seismic activities have spooked virtually the entire world. However, we expect that these actions will end much sooner than generally expected. It remains that the entire world…yes, the entire world…is focused on the very same indicator, namely, inflation. As signs of a decisive down-turn in prices emerge, we expect equity markets to soar. Such is the volatility in capital markets at this time.
CASH AND CURRENCIES
Cash levels unchanged
- Cash and equivalents’ continue to offer a trade-off between acting as a buffer against volatility while simultaneously reducing purchasing power as inflation remains elevated.
- We have elected to maintain cash near neutral levels this quarter.
Currency risk management in focus
- European currencies, particularly the euro and British pound, have undergone a significant depreciation this year, due in part to monetary policy divergence and fears of a continental energy crisis.
- While these currencies could remain at depressed levels for an extended period of time, risks are now asymmetrically skewed to the upside, as financial markets have already digested a plethora of bad news.
- European currency exposures have been unhedged in client portfolios this quarter.
Staying overweight equities
- Sentiment towards equities remains depressed as investors continue to grapple with tightening financial conditions and an array of geopolitical headwinds.
- However, valuations and dividend yield remain amongst the best predictors of long-term equity returns, and both have undergone a significant restoration this year.
- Equity positioning remains overweight and has been modestly increased this quarter.
Moving into US value
Despite our view that inflation is currently in the process of receding, we do not expect a return to the disinflationary environment of the 2010s any time soon.
A period of above average inflation would not play to the advantage of growth stocks, whose higher valuation multiples and long-term growth projections make them relatively more interest rate sensitive than value stocks.
We have decreased exposure to market capitalization-weighted US equities and initiated an overweight position in US value stocks.
GLOBAL FIXED INCOME
Modestly decreasing fixed income exposure
Rising interest rates have made fixed income a much more serviceable asset class within the context of a balanced portfolio.
However, with flat (and in some cases inverted) yield curves, developed market investment grade debt fails to offer meaningful compensation for the inherent interest rate risk at most maturities and credit quality ratings.
Fixed income exposure has been modestly decreased and remains below neutral levels in client portfolios.
Remaining overweight credit
Notwithstanding our top-down view of fixed income noted above, there are a number of pockets within global bond markets which look increasingly attractive.
Spreads on sub-investment grade US corporate bonds and loans have widened materially, despite very low default rates, relatively healthy fundamentals and low refinance risk.
We remain overweight US corporate debt in client portfolios.
OPPORTUNITY INVESTMENT HIGHLIGHTS
Liquidating Hong Kong stocks
Hong Kong should see an economic boost from the recent easing of COVID lockdown restrictions, but numerous challenges remain.
Specifically, imported (and tightening) US monetary policy and less of an onus for US-listed Chinese stocks to move their primary listings to HKEX detract from the investment thesis.
Hong Kong stocks have been liquidated in client portfolios this quarter.
Initiating secular equity themes
We view the recent weakness in lithium and biotechnology equities as an attractive entry point into asset classes that are supported by well-entrenched long-term themes.
Lithium demand should continue to boom as electric vehicle adoption proliferates, while biotechnology aligns with aging demographic profiles in major economies worldwide and new opportunities arising from the advent of mRNA technology.
Exposure to lithium and biotechnology equities have been initiated in growth-oriented strategies this quarter.