Quarterly perspectives 2022 Q3
Tavistock Asset Management
Quarter 3 2022
Written by Titan Asset Management Investment Team
Since the 30th of June 2020, which is the date we use for monitoring performance since the start of our strategic review process, the ACUMEN Portfolios have delivered strong risk-adjusted returns, largely outperforming their respective IA sector. On an absolute basis the ACUMEN Portfolios have fallen in value since the start of the year. This is unsurprising given recent developments. However, on a relative basis the funds have held up remarkably well, particularly at the higher end of the risk spectrum and versus the IA sector peer group against which we measure performance. On a 2 and 5-year basis, and since inception, the funds continue to perform well.
There are a variety of reasons for strong relative performance. Specifically, our active currency management strategy, commodity carve-out, defensively minded and dividend-focused equity exposure and short-duration fixed income bias. Each of these topics are covered in a series of blogs available on the insights page of our website.
Starting with the former, our decision to unwind a substantial portion of our US dollar FX hedge has really paid-off this year given the significant move in GBP/USD from 1.35 to 1.22. Despite the strengthening dollar, some of the greatest gains have come from the commodity carve-out, with positions in gold and gold mining stocks outperforming the MSCI World by 10% and 22% respectively and our broad based exposure to commodities outperforming by almost 45%. Turning to equities, our defensive bias, particularly in the US where we have exposure to healthcare and low volatility stocks, and our quality focused dividend equity strategy, have also performed well. In fixed income, our prior preference for short duration government bonds contributed to strong relative gains given the sizeable, and historic, sell-off in long-dated US Treasuries which saw the 20-year Treasury yield surge from around 2% to approximately 3.4%. In summary, we are very happy with performance across asset classes with much of this also attributable to a number of strategic changes.
Looking back at the Q2 Quarterly Perspectives, our core theme was that economic growth will moderate but remain robust overall even as inflation persists at elevated levels. That narrative has since shifted. There are growing concerns that many countries may enter a recession, either later this year or next. The key question however, and top concern amongst investors today, remains inflation. Future market direction will be driven by this unknown quantity and associated Fed response function. If the Fed, and other central banks, tighten too much, it increases the probability of recession. Tighten too little and inflation becomes the dominant concern. Each outcome will have starkly different outcomes across markets. Jerome Powell is trying to thread the needle and engineer a soft landing somewhere between the two but history suggests that might prove difficult to achieve.
Over the last month or so, investors have turned positive on risk assets. This preceded a ‘dovish’ 75bp hike which Powell described as ‘unusually large’. In signs of a potential pivot, he stated the full effect of prior rate hikes had not yet been fully felt and that going forward it may be appropriate to slow the pace of tightening. The need for caution is relatively self evident given how quickly the economy slowed in the previous cycle once rates hit 2.5% and the recent Q2 US real GDP miss, at -0.9% versus expectations for +0.4%. It seems, for now, that the tone has shifted from fighting inflation at all costs, towards a greater emphasis on the potential downside impact on growth. The cynic in me thinks that is not a coincidence in the run up to mid-term elections.
This outlook is consistent with growing signs that inflation may have started to peak. Forward-looking indicators, such as breakeven rates and inflation swaps are pointing towards 2% inflation in one-to-two years’ time. Commodity prices have fallen as a result of the slowdown in global growth and the recent collapse in US housing demand should feed through to house prices and rental inflation which, as a structural driver of core inflation, has been a lingering concern for some time. Money growth has slowed substantially and wage growth is also slowing with real wages falling globally. Looking at the Dallas Fed survey, as a potential leading indicator, there is a real possibility that inflation peaks this year before falling to more reasonable levels.
The market is now discounting the Fed funds rate to peak at around 3.6% in Q1 next year, before falling further out the curve. We believe that the combination of slowing economic growth and peaking inflation could reduce the Fed’s appetite to tighten policy later this year.
However, given the magnitude of the recent relief-rally across equity markets, we think it is hard to make the case for further sustained gains given deteriorating economic data, such as falling PMIs, and the outlook for corporate earnings. The lack of bad news in second quarter earnings is a positive, but much of that growth came from energy companies which have benefited from higher oil and gas prices. At the same time there were growing signs that many households are getting squeezed and if the consumer starts to balk at what companies are charging then this could start to hit the bottom line. The market seems to be underestimating this risk. In the same way as quantitative easing and the resulting inflation led to outsized earnings power for many companies, the shift to quantitative tightening, and falling inflation, is likely to hit the bottom line. This means that it is likely premature to call an end to the equity bear market and whilst the 30% decline in the P/E ratio for the S&P 500 was responsible for leg one, a notable decline in earnings per share could contribute to a renewed bout of risk aversion. Technically, the S&P 500 is at a key level too, approaching the 200-day exponential moving average and a key Fibonacci level.
Following the strong labour market numbers last week, and low unemployment rate, many investors might question that outlook and downplay the rising recessionary risks. But this is happening against a backdrop of declining GDP and the highest pace of firings in nine months. To that extent last weeks numbers seem a little unsustainable. The reality is many companies are yet to cut labour, in an attempt to protect margins, and historically low unemployment conversely increases the odds of recession moving forward.
Turning to the ACUMEN Portfolios, we have made a number of changes to reflect our shifting outlook. First and foremost, we have reined back our exposure to dividend-paying equities. As specified in the final paragraph of Rotations & Dividends, peak inflation, declining corporate earnings and a shift in risk sentiment erodes many of the tenants underlying this strategy. Further, valuations are now significantly less compelling as evident from the chart below which shows we have now reached our target level and key resistance versus generic global equities.
As a result, we have removed our allocation to European value stocks, which face a number of headwinds in their own right. In its place we opened a new tactical position in US technology companies. The goal here is to reintroduce some growth exposure to add balance to the funds, via high quality cash generative companies in this space, such as Microsoft and Apple. The catalyst for this decision was a rebound in the growth:value ratio we monitor for risk management purposes and a decisive move lower in US Treasury yields (more on this in the fixed income section) which we think has further to run. The sell-off in tech has been dramatic and, all-else-equal, lower long-dated bond yields should support duration sensitive growth companies by flattering the net present value of future cash-flows.
Across the rest of the equity proposition we retain our preference for defensives over cyclicals given our negative outlook and expectation for declining inflation expectations, shown in the chart in orange.
Finally, we think certain pockets of the commodity complex could start to come under some pressure in the macroeconomic environment laid-out above. As a result we have slightly reduced the size of our commodity carveout.
Consistent with our outlook for deteriorating economic growth and peaking inflation, Fed policy may soon look overly tight, reducing the Fed’s appetite to tighten policy meaningfully over the second half of this year. Should growth and inflation continue to weaken, we think this could be the time to start lengthening duration across our fixed income exposure. We set a downside target of around 2.25% for the 10-Year US Treasury yield, versus the current yield of 2.80%. This target is consistent with a head and shoulders pattern prior to re-entry to the decade long prior range, a key Fibonacci level and the 200-day moving average, in red.
Whilst arguably somewhat early, we have adjusted the composition of our US bond allocation accordingly. Our preferred way to play this theme is in the belly of the curve, at the 3-7 year duration, where we see the greatest upside potential.
In credit, we retain our preference for high quality. Spreads have widened meaningfully over the last few months but remain below historic peaks suggesting risks remain skewed to the upside. Our preferred way to play this theme is via sustainably-linked European corporate bonds. We reduced exposure to developed market high yield bonds late last year as these firms will have higher refinancing costs in the coming period relative to prior historic lows. Instead we prefer to take risk via quality emerging markets where we retain a sizeable allocation to Chinese local currency bonds. This position has performed well since inception. It demonstrates low correlation with the majority of the bond market and benefits from the People’s Bank of China’s current easing policies, relative to developed and emerging market peers. Further it stands to benefit structurally from the growing allocation within international bond indices over the long-term.
Global equities suffered their worst first half to the year in over half a century with the MSCI World losing just over 20%. Multi-decade high inflation has forced the Fed along with many central banks across the globe to embark on rate hiking cycles from record low levels. The tightening of financial conditions, the squeeze on consumers and the saddening Russia-Ukraine conflict have all added to recession risk which in turn has led to many major equity indices falling into a bear market.
Our defensive positioning coming into the year proved pivotal in protecting the portfolios against the large losses seen across the markets and we believe defensiveness remains prudent given the plethora of macroeconomic headwinds in play. Our minimum volatility exposure has been a positive contributor to relative performance this year and we see volatility remaining elevated over the coming months. Whether we are in an economic slowdown, a shallow recession or a deeper contraction (we lean towards the former two scenarios), minimum volatility investments are suited to these regimes and offer stability to the portfolios. The US healthcare sector is another defensive theme we continue to favour. The inelastic demand for healthcare services and products combined with the sector’s relatively strong pricing power provides some insulation from rising input costs and slowing growth. Historically, earnings of healthcare companies tend to lead the broader market in recessionary periods providing relative downside protection.
We believe quality income strategies are poised for further outperformance given the inflationary backdrop as investors seek stable income. Our remaining exposure to dividend paying companies is focused on those with strong free cash flow that can sustain their pay-out ratios throughout the market cycle. Until we see a meaningful cooling in inflation data and/or a pivot from the Fed, the upside case for these quality-focused dividend stocks remains intact.
Having a tactical position in Chinese A Share equities generated significant alpha last quarter as investors began re-entering the region after a challenging year. While China’s Zero-Covid policy will be a driver of volatility, valuations are attractive and we appear to have reached peak negative regulatory news flow. With China in a different stage of the economic cycle to its developed market peers and in a position to provide monetary and fiscal stimulus, Chinese stocks may sustain their recent rebound, though we are vigilant of the risks.
Q2 was far more turbulent for physical assets than the preceding quarters. Energy markets have shown some residual attachment to fundamentals, however, there has been a stark decoupling between market pricing and the macro environment for many commodities. In our last publication, we highlighted Russia, China, the US Fed, and demand destruction as the 4 catalysts for physicals markets and indeed they have all played their part.
Sadly, the war in Ukraine shows no sign of abating in the short-term. This has, amongst a plethora of other factors, highlighted the energy dependency crisis in Europe, one with no obvious near-term solution. This should provide further support to energy prices. Gas and other energy products are contending with rampant inflation and supply side weakness on one hand, versus fears of recession and demand weakness on the other. The overall balance leaves us relatively constructive on base energy, especially when combined with US policymakers drawing down strategic reserves of 1 million barrels per day in attempts to curb inflation, and the International Energy Agency warning global inventories are at ‘critically low levels’.
On US policy, sustained high inflation readings have prompted further action by the Fed, with our gold position returning approximately 10% relative outperformance in Q2. This provided good protection and alpha in the portfolios, however recent volatility has led to a rough start to Q3 for gold prices due to a rampant US dollar. We believe this position still holds merit as a recessionary hedge especially if we enter a period of stagflation.
We are less concerned with the speed of growth slowing in China. With political machinations requiring a strong economy and inflation readings far lower than western counterparts, there is spare capacity to stimulate further and a strong rationale to do so by the People’s Bank Of China. With the Chinese economy being in a different stage of the economic cycle to most of the world, the rapid fall in base metal prices seems unwarranted. However, market sentiment has a firm upper hand over fundamentals and this environment could continue whilst recession fears remain high. To that end we recently sold our position in global miners, which fell beyond our stop loss in June.
Currency markets for the first half of the year have been focused on global monetary policy, with the US Federal Reserve attracting the most attention, in anticipation of what higher interest rates will mean for the US dollar. This has led to significant appreciation in the US dollar Index of over 10% since the beginning of the year. The strength can be attributed to several factors, the main reason being widening interest rate differentials in the US compared to the wider market, where other central banks lag the US curve trajectory. Comparatively, the US bond market has become increasingly attractive to investors, pushing up the demand for US dollars. Furthermore, the deteriorating global socio-economic environment, following the ongoing Russia-Ukraine conflict, rising political tensions and recent equity market sell-off has caused a rush to safety in markets. Asset allocators have flocked to the US as the safest place to weather the storm, driving additional demand for US dollars. During previous Fed hiking cycles, as shown in the chart, the dollar index tends to appreciate up to a peak (red dotted line), which is usually hit prior to rates reaching their peak (blue dotted line). This is due to the forward-looking nature of markets pricing out the rate path before the Fed. We expect a similar price reaction this time around too, reinforcing the importance of active currency management across the ACUMEN Portfolios.
Looking ahead we expect inflation to peak but remain elevated. This means there is room for further US dollar appreciation, up to a point where markets have fully priced out the higher levels of inflation. The counter to this base case would be inflation commodity sensitive currencies such as the Australian and Canadian dollars which could rebound in this alternative scenario.
Whilst we think inflation may peak this year, it is likely to remain elevated relative to historical standards. On the premise that yield remains a desirable investment objective moving forward, and given our recent decision to pivot slightly from dividend paying equities, this raises the question of what alternatives exist that also tap into this theme. One such alternative is in property, the most liquid and cost-effective method to gain exposure to which is via real estate investment trusts, or REITs. Given a requirement to pay 90% of income out as a dividend, REITs become an attractive way to secure an alternative yield within portfolios. It also provides added diversification benefits, to a traditional 60/40 portfolio, at a time when volatility remains elevated and we are reducing our commodity exposure.
As shown in the chart, there is a high historical correlation between dividend paying equities and REITs. Whilst the former has significantly outperformed over the last year, to our benefit, we think this could be an interesting time to rotate exposure between the two for comparatively better risk-reward moving forward. The key rationale for this trade is that property is mission-critical to the ongoing functioning of many business models. As such, rental yield tends to be more stable than that provided by other non-real estate companies which have greater scope to cut or suspend dividends throughout a period of declining economic activity. This is compounded by contractual agreements which tend to lock firms in on the rental side.
Clearly there are risks to this trade. At the macro level, economic growth, interest rates, inflation, demographics and government policies and subsidies play pivotal roles in shaping the performance of these securities. At a micro level, there are variations by region and sector and through quantitative metrics, such as vacancy, cash-flow, and capitalisation rates; although in truth, these are the numerical manifestations of the macro-economic factors. Our preference would be to take targeted exposure via high-quality multi-national companies locked-in for the long-term. Naturally this is difficult to achieve via ETFs which track broad-based indices. That said, REITs are an interesting alternative that offer differentiated exposure and an asset class we will be watching closely to help navigate through these difficult and unprecedented times.