More pain threatened

With sentiment so weak and global risks so stark, keeping money in cash is not a bad strategy. Rates are higher than they have been since the start of the millennium. Central banks will raise rates even more before year-end. To move out of cash requires a view that the end of the rates cycle will bring relief to other asset classes, allowing them to return to beating cash. Higher yielding short-maturity fixed income might be a first step. Or it requires taking a longer-term view. Historically, global equity real returns have averaged between 6%-7%. The short-term risk adjusted return is likely to be worst but at some point the Fed will be done and the war will be over. Committing to that long-term view is, however, very challenging today even if, ultimately, profitable.

War footing

Sentiment remains weak, risk aversion remains high and there continue to be few places to hide in financial markets. The big macro themes dominate the idea that there is value in some financial assets. Interest rates are still going up and central banks are not flinching. Inflation is uncomfortably high and has continued to surprise to the upside. Economic growth is slowing as higher rates start to impact on borrowing costs and housing markets. The energy crisis is not going away with OPEC pushing for production cuts and higher oil prices and European countries planning for potential energy blackouts this winter. Putin is threatening an escalation of the conflict in Ukraine with the use of nuclear weapons. The combination of all this is markets on the edge. Risk indicators are elevated, and we saw how bad things can get with the debacle in the United Kingdom last week.

Investors have suffered big losses this year and are unlikely to try and recover any of that in the run up to year-end. Next year is a new year, with a reset to P and L.  But even then, the big picture may not have improved much. The global economy has been hit with massive shocks in the last few years and policy making is all over the place. There are tensions between fiscal and monetary policy. There is no sign of international co-operation to deal with pressing economic matters, even if there is a solid alliance against Putin’s aggression. That may be tested even more given the increased rhetoric from Moscow in recent weeks. Shortages of goods, workers and energy are symptoms of a global economy that is not working, and that means lower returns to businesses and investors.

Searching for the pivot

In the short term, the hope amongst investors is that central banks will soon conclude that enough has been done in terms of monetary tightening. Expectations of a pivot were premature in July. Today, it is likely to be a combination of falling inflation, much weaker economic data and increased financial instability that eventually causes a pivot in the monetary policy cycle. Importantly, central bankers have resisted the idea that they are close to the end in the fight against inflation. Markets continue to price in further rate hikes in the short-term - . another 125-150bps in the US before year-end, another 100-125bps in the Euro Area and another 200-225bps in the UK. Coming on top of what central banks have already done, this is still quite a bit of monetary tightening. That is more pain to come.

Hopefully, next year will not see anywhere near that amount of tightening. Investors should, for all intents and purposes, view the end of this year as being the close to the “peak”. It all depends on how quickly central banks respond to weaker data and evidence of slowing inflation. If inflation doesn’t slow then rates will go up more and a global recession will follow.

Bad macro news is good market news

The most benign scenario would be that the pivot comes from lower inflation numbers. That would allow interest rate expectations to come down and be positive for bonds. A rapid weakening of growth data, and lower inflation, would also be positive for bonds as focus would turn towards central banks having to ease at some point in response to growing recession risks. GDP forecasts have already been slashed but seeing slower growth in actual numbers would be the realization that equity markets need to take their earnings growth expectations down a lot further. They appear to remain too high. For example, the consensus EPS growth forecasts for the MSCI world equity universe remains at 6.5%-7% for the next 12-months.  This is below average, but not at recessionary levels. Paradoxically, a data-slowdown generated downward revision to earnings might help equities find a bottom. A S&P500 in the low 3000s would be one I reckon.

UK volatility spikes

The other cause of a rate pivot might be a deterioration in financial market conditions. We get a sense of that at the end of September in the UK when the Bank of England was forced to intervene in the gilt market. Rising yields generated a large increase in cash-collateral calls amongst UK pension funds with leveraged LDI (liability driven investment) overlays. This led to further selling of gilts and a doom-loop looked to be setting in. The Bank broke the volatility circuit and stabilized the market. It did so with a policy, albeit a temporary one, that conflicting with the tightening bias of the Bank and its desire to start reducing the size of its balance sheet. The immediate cause of the crisis was the realization that the new government’s fiscal plans (expansionary) were also in conflict with the monetary stance (tightening). That remains the case, meaning more volatility in the gilts market can’t be ruled out.

Risk indicators flashing

It is an example, a localized one admittedly, that markets can become disorderly when pricing changes rapidly. We’ve had a huge increase in market interest rates this year and that is now impacting on the real economy. Mortgage rates are going up and that will impact on housing markets and the providers of mortgage finance. Re-pricing of assets will have weakened some balance sheets. Market risk indicators are certainly pointing to increased fear – bond, credit and equity implied volatility is high and FX basis swaps have widened to levels that usually indicate panic buying of US dollars for funding needs. We are clearly not at the stress point yet, but I have seen enough policy responses to bouts of market volatility in my time to not rule this out as a trigger to a change in central bank policy.

2022 was the year of bulk tightening

The pace of rate increases that has defined the last few months will fall and eventually stop. Next year won’t see the same kind of monetary tightening (Fed Funds won’t be heading to 8%!). Markets are cheap and investors are likely to be sitting on a lot of cash come the New Year. Cash pays these days so that is not a bad thing when sentiment is weak. But sentiment could shift with the end of the rate cycle. One year of negative returns in fixed income is quite unusual, two consecutive years is unheard of. So bonds, at least, should be a consideration for putting cash to work in markets.  

Hurdle rates

The problem now is that higher rates on cash have raised the hurdle for everything else, particularly when there is so much macro and political uncertainty. The valuation argument for bonds and equities is reasonable and higher bond yields have restored the diversification benefits of fixed income. Yet sentiment is so poor that some good news is needed to get investors to put cash to work. Is it yet worth moving out of US dollar cash yielding 4% to go into riskier assets? The hurdle rate in Euro is around 2.5% and sterling, around 5%.

Short-end bonds pay nicely

If investors don’t want to take much price volatility, short-duration fixed income now provides a good pick-up over cash without making a big jump in risk. The 1-5 year maturity investment grade corporate bond indices (Bank of America/ICE range) in US dollars, Euro and sterling currently have a yield-to-worst of 5.36%, 3.80% and 6.57% respectively. Taking more credit risk boosts the available yield even more – European high yield at 8.24% and US high yield at 9.2%.

These corporate bond yields are attractive for investors. They are not so good for the long-term health of the economy. Borrowing to finance investment at these yields is likely to represent a high real yield when considered over the course of five to ten years, and threatens an increase in defaults in high yield when companies come to having to refinance debt.

It is hard for equities to compete short-term with these yields, but long-term, with returns determined by sales growth and profitability, equity returns should start to look more attractive when short-term yields come down. But for now it is still better to think about yield with little risk, until the pivot is genuine and the dark clouds over the global economy disappear.