Apostle Funds Management’s Steven Spearing provides insight in light of market volatility, geopolitical pressures, the risk of recession and what implications this has on asset managers.
Systematic risk in financial markets is alarmingly high
Strong headline returns across asset classes have masked the concerning level of volatility in the financial system this year. The US 2Y Treasury yield reached record levels of volatility in March 2023, exceeding the volatility seen during the GFC. When this level of volatility occurs in short-term interest rates, the ‘safe’ part of financial markets, there is an alarming level of systematic risk in the financial system. We’ve already seen several large bank failures, but history suggests there could be more damage to come.
The shift in narrative has started, but inflation remains a concern
The shift from inflation to addressing the resultant economic impacts would emerge this year, and this has clearly started to take shape. While the recent increase in financial stability risks has caused central banks to reassess their rate hike trajectories, they have continued to raise interest rates and inflation remains a concern. However, even though inflation remains high, the economic outlook has continued to deteriorate, it should drag inflation down along with it, which means that the peak in rate hikes is now likely to be imminent, but that central banks will choose to be more patient in holding interest rates higher for longer over any further substantial rate hikes, in the absence of any unforeseen inflation shocks. Rates market pricing continues to point to rate cuts this year, which is confusing, unless the outlook is crisis-like, which is a scenario not being priced into equity markets or credit spreads.
Higher inflation and interest rates are likely to persist, jobs market in focus
Inflation has for the most part been continuing the trend of disinflation globally, with headline CPI inflation measures clearly peaking. However, high core services inflation is keeping overall inflation sticky. Core services inflation is particularly sensitive to the higher wages that private sector firms are offering as a tight labour market makes filling vacancies difficult. This puts the labour market in focus as a key pillar underpinning sticky inflation. The Beveridge Equation, which measures tightness in the labour market as job openings minus unemployment, is still significantly higher than any point in history prior to this cycle, which is why labour cost inflation is yet to peak. Simple economics suggests that core inflation will stay elevated until labour costs have been subdued, so it is logical that the Fed should keep financial conditions tight until the labour market begins to weaken. The good news is that there are signs that the labour market is starting to ease.
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Well into recession territory
Leading indicators have continued to drift lower across major economies and are now well into recession territory. Whilst major economies are more resilient than they have been prior to previous recessions, highlighted by the historically strong labour market, this resilience has brought sticky inflation and suggests financial conditions may need to get tighter across the globe. Whilst we think there is enough fundamental strength in the global economy to avoid a severe downturn, we expect a moderate recession in most major economies if there is any hope of inflation returning to target ranges. Central banks are facing the consequences of the post-pandemic stimulus period as they must now destroy the beast they created. A pillar of strength for the consumer, along with a tight labour market, has been personal savings which jumped significantly in 2020 amid lockdowns and stimulus payments. However, personal savings have fallen to below 5% which compares to an average of nearly 8% in the 5 years preceding the pandemic – more concerning when you consider the low unemployment rate. This bodes poorly for forward looking consumer activity.
So, what does this mean for asset allocation?
Interest rates remain a focus and while extending duration has traditionally been in the recession handbook, we are not yet drinking from the duration punch bowl. This is for two main reasons:
1) Given the current shape of the yield curve, we believe there are better risk-adjusted opportunities to gain fixed rate exposure in the short end of the curve.
2) We feel there is a longer-term potential for long end rates to rise as persistently higher inflation leads investors to demand a higher term premium.
Higher yields, particularly in the short end of the curve in higher rated bonds, are a gift to investors who has been starved of income for years. Short-end government bonds offer strategic value as a recession hedge, particularly given the level of inversion in the US yield curve. Every yield curve inversion in the last 60 years has been corrected by the short-end, with 2-year rates generally tightening 2-3 times as much as 10-yearrates. Given recession is the base-case scenario, we think short-end rates are an essential allocation for the downside protection and attractive forward price returns they offer in this scenario.
Credit spreads are undoubtedly vulnerable
This warrants a cautious approach and defensive tilt. We, and our sub-investment managers, favour marginally increasing credit quality, focusing on reducing company specific risks and focusing on recession resilient areas of the market. Thankfully, high yield credit fundamentals are coming from a position of strength and the maturity wall is low, so while credit spreads may come under pressure, we expect defaults to only be moderate and in line with historical averages, so long as a recession (if we have one) is not deep and drawn out. Where we choose to get our higher risk exposure from, valuations are more compelling. Floating rate bank loans at implied yields near 10% appear to be rewarding investors adequately for the current outlook.
