What our House View means for asset allocation and portfolio construction.
- Aggressive interest rate hikes in 2022 set the stage for a ‘mild’ global recession that is just beginning. High inflation means monetary policymakers will likely err on the hawkish side, lifting the front-end yields and inverting yield curves
- Having rallied into late-2022, credit and equity markets are expensive given the central scenario of a downturn, the risk of a global hard landing, and substantial yield provided by cash
- As the slowdown sets in, rate levels and volatility should subside; eventually this will help risky assets rally, and the dollar decline
The past year has been one of rapid regime change; inflation reared its ugly head in 2021, but did not prove transitory, and Russia’s invasion resulted in an energy shock and fiscal response that forced inflation higher and pushed growth lower.
A new regime means positiveyielding cash is now more attractive than at any time in the post-GFC era
This shattered the post-GFC era of low inflation and central bank accommodation, and the accompanying 12-year bull market both equities and government bonds.
The bear market for fixed income arguably started in July 2020, but severe losses began in early 2022, just when equities also began to respond to significant, synchronised global monetary tightening.
The dollar similarly showed some strength throughout 2021, even as emerging market central banks raised rates ahead of G10 countries, but the greenback’s gains accelerated into the past year, driven by risk aversion and outflows from EM and Europe, as well as higher real rates.
Because of the ‘flipped’ positive correlation between bonds and stocks (particularly growth and tech), treasuries and gilts were no longer a useful hedge: they were the cause of the risk and volatility!
Cash, offering a decent yield and – assuming inflation abates – a store of value as well, is for the first time in many years a viable and essential tool for to achieve target returns and manage risks for investors.
Recession is expected by markets, but downside risks mean it is premature to position for recovery
Looking forward to 2023, the global economy is expected to enter a mild recession as growth slows further and central bank policy remains tight.
In this environment of below trend and declining global growth, growth-sensitive risk assets have tended to perform poorly. In 2022, this certainly proved to be the case and for how long this trend continues will be a key question for investors in 2023.
Our measure of market pricing of the economic cycle (Marketcast) suggests that the market generally moves roughly three months ahead of the economic data as investors try to price in their forward-looking expectations for growth.
Current market pricing is consistent with our view that global growth will continue to weaken in early 2023 (Figure 1). While markets have seen a significant rally into year end, we believe it is premature for markets to be pricing a recovery in the economic cycle, even considering their forward-looking nature.
Figure 1. Aviva Investors market implied pricing of global growth & Nowcast
As more economies move towards recession the need for further monetary tightening will diminish and therefore, we have likely seen the peak in rate acceleration.
Whether or not slowing growth is enough to allow central banks to pause and eventually ease in line with market pricing remains to be seen. What we do know, however, is that the rate environment can have significant implications for expected asset returns wherever we are in the economic cycle.
Figure 2 shows excess returns of different asset classes based on where we are in the economic cycle (using our proprietary quadrant model) and the rate environment relative to the prior 1-year average. This analysis highlights the cyclical nature of the dollar and suggests some further appreciation in early 2023 and therefore we prefer to be long USD for now. Later in the year as the slowdown sets in and rate levels subside, the dollar will likely decline.
Figure 2. Asset return by quadrant
Expected returns in credit can also be informed by the global growth cycle. Figure 3 shows US IG & HY spreads where the colour reflects the growth quadrant. In below trend and declining environments spreads typically widen while spreads usually tighten most significantly as the global economy recovers. There is scope for credit to outperform once the recovery is on the horizon and can be reasonably be priced in by the market.
Figure 3. US Credit HY & IG OAS by growth quadrant
The rapid repricing of hiking cycles across G10 countries and extended hiking cycles in Emerging Markets have taken global government bond yields to their highest levels since 2008 and make us close to neutral on the outlook for government bonds.
Risks are two-sided: if inflation is more entrenched, then despite economic weakness, policymakers will have to remain restrictive, or perhaps even fine-tune with additional hikes, after a pause.
The rate cuts that are implied by inverted yield curves, from Brazil to Central Europe to the US and UK, could get priced out or pushed further into the future, and that would punish bondholders with capital losses, in addition to negative carry. The upside scenario for bonds is that inflation either proves transitory, or that a hard landing occurs, necessitating lower yields to cushion economic distress.
Emerging market bonds are becoming attractive, but still will face some headwinds in the early part of 2023. Local government bond yields have risen from sub-6 per cent at the beginning of the year to over 7 per cent but these are not high in real terms in aggregate.
Hard currency EMBIG spreads are 100bp above pre-pandemic levels, and offer adequate protection compared to defaults and recovery, but are well below their peaks and HY in developed markets (Figure 4).
Figure 4. EM (GBI-EM yields and EMBIG spreads)
The end of rate hikes will be the catalyst for the strong dollar to stop inflicting losses, but perhaps just as important, wide variation in valuations and fundamentals will continue to provide ample relative value opportunities within both asset classes.
Commodities are an important factor and asset class in their own right: a cyclical downturn has eased industrial metals, but tight supply mean energy prices will remain supported, with $80-100 oil needed to spur production and induce some demand destruction. Natural gas remains constrained by Russia, and this keeps a floor on coal and crude, while also feeding through to other downstream commodities and goods.
A trend of 2022 that investors will be watching moving into 2023 is the equity-bond correlation.
From the early 2000’s onwards equity prices were reliably negatively correlated to bond returns. In 2022, however, that long-standing negative correlation broke down and became significantly positive, more akin to the relationship prior to the 2000’s (Figure 5).
Figure 5. US Treasury and S&P 500, return correlation - 2 yr window, monthly changes
If the equity-bond correlation is no longer reliably negative, it will likely have significant implications for multi-asset portfolio construction. As fixed income assets may no longer act as risk reducers, a higher expected return may be demanded to entice investors to hold them in their portfolios.
Bond allocations are likely not the only asset class under scrutiny as we enter 2023. After nearly four decades of gradually declining yields, the higher rate environment increases the probability that financial distress exposes vulnerabilities.
Figure 6 shows that many measures such as repo markets, bid-ask spreads and dislocations on curves are showing meaningful stress. This also indicates opportunities for relative value trades in mispriced or less liquid assets.
Figure 6. Financial stress is building, but not (yet) extreme
In short, real yields, corporate bond spreads and equity risk premia are all likely to be structurally higher going forward – making some of the spread-widening and equity de-rating permanent. This, in turn, could encourage investors to shift allocations back towards less risky assets while still generating the same or better expected returns.
This difficult environment keeps us neutral on equities. The markets have incorporated much of the downturn in the economy and partially adjusted for the higher real rate environment, in our assessment.
For the longer term, average excess returns are expected, but in the coming quarters, the main drivers of volatility will be the probability of a deeper global recession, the ability of monetary authorities to cease their deliberate tightening, and based on those inputs, analysts’, and investors’ expectations of earnings.
In expansions, inflation and higher rates are part and parcel with bull markets and strong returns, but in the current stagflationary regime, high inflation is not beneficial for margins, and produces rate hikes that push down equity prices (via higher discount rates of future cash flows, particularly harmful for growth sectors).
To be more constructive, we would need to see earnings forecasts fall along with multiples, which then sets the stage for multiple expansion as growth accelerates from low levels (Figure 2), even as earnings may take several more quarters to recover.