Hawkish pivot

Just how hawkish is the Fed?

Pretty hawkish.

Powell also made it clear that the line “transitory” has outlived its usefulness, and will be retired. Inflation, in their view, is here to stay, in absence of a policy response.

Now, the robust economy, and historical outcomes of prior variants underpin equities. Most of Omicron’s predecessors came to nothing; Delta was deadly, but we got past that too with modified vaccines, and it seems reasonable that we can do so again, given the comments of the COVID vaccine producer management teams, with time.

The pockets of dramatic overvaluation, however and high general valuation, do not.

Ergo, underweight risky assets, but the trade off, as always, is about preventing the reflexive decision to thunder in or out of an asset class like equities in its entirety.

SAA

There is little evidence of unsustainable leverage in US, European or Japanese households, of the sort that produces systemic risks.

There is plenty of pent up saving (from prior fiscal support measures) and, given the magic of capitalism, every reason to believe that inflation will be wrought out of the system, and if not, then eventually by the Fed.

There is plenty of evidence that the economy is otherwise performing well (retail sales, housing investment). Indeed, on that housing point, most recessions are preceded by a marked slow down in housing starts, and housing sales, and that hasn’t happened here.

If anything, those data continue to point to strength, which is part of the reason that JHX (James Hardies) has been eating into our portfolio performance (we don’t own it, great company, but overvalued, however it continues to chip away at relative performance).

Equity risk premia remain broadly within historical ranges, and compared to bonds (TINA) are attractive. Any positive expected return asset class will tend to attract flows when the alternative is negative real returns after tax.

As such, there are compelling reasons to allocate capital to risky assets in-line with one’s strategic asset allocation, on the assumption that one is in the right risk profile to start with (e.g. the correct alignment of willingness and ability to tolerate risk, in other words, the right product for the client).

DAA

So, what’s the point, in context of DAA.

a) acknowledge that the Fed has changed its reaction function.

We have a lovely slide, in our process docs (which looks a touch blurry below as I try to squeeze the image into WordPress) that highlights how important the reaction function is to forecasting the outlook for rates, growth, inflation).

b) acknowledge that the change is to prioritise inflation, which means accelerating the taper, and pulling forward the timing of rate hikes. This is where concerns about valuation come in.

Most of the time, markets perform well during the early phase of a tightening cycle. However, if the starting point is one of very high valuations, and signs of excess in certain pockets (e.g. tech, staples, health) exist, there’s no reason to expect this dynamic to hold.

That’s where the underweight to equities, at the margin, at the portfolio level comes in, and the overweights to cash and alternatives, as well as the portfolio tilt towards Quality and Value, and away from Growth.

If the sell-off is less about Omicron, and more “an excuse given high valuations and the enormous run in asset prices since May 2020”, then Quality Value stocks are more likely to outperform expensive Growth stocks, to our mind.