Macro markets

State of play

The Fed’s pivot to a more hawkish tone saw the US dollar lift, credit spreads to widen, risky assets to fall (commodities, sharemarkets) and the relentless flattening of the term spread continues. These are classic signs of monetary policy tightening.

And that was before Omicron showed up, which really sat on risky assets, and investor appetites more broadly.

The term spread (the difference between the yield on a long dated bond, like the 10 year treasury, and shorter dated ones, like the 2 year treasury) flattening is a major headwind to banks, who borrow short and lend long.

We are underweight the banks on valuation grounds, and on concerns about the sustainability and quality of loan growth in Australia.

The higher US dollar tends to result in commodity prices weakening, as commodities are denominated in USD, which makes them more expensive as the dollar rises.

The USD is also a “flight-to-safety” currency, any prospective slow down in expected global growth, due to tightening, or Omicron, or simply elevated risk aversion, lifts the dollar, and shows up as reduced demand for commodities.

Despite our overweight to energy, we are on net underweight commodities, with sizeable underweights to gold, copper, other precious metals, iron ore, steel and coal.

Cross asset performance

Value, as a style, as an investment strategy underperformed again, relative to Growth. Omicron may cause “secular growth stocks”, whose earnings are not dependant on the overall economy to perform well, however we also think that the higher inflation environment is a material headwind to growth stocks, through higher interest rates, as well as the good old fashioned “valuation” argument.

By that we mean that markets are likely modestly overvalued, with investors looking for a reason to sell, and growth stocks are amongst the most overvalued in the market, and therefore the most vulnerable. We would not be confident that a lift in COVID case rates would lead to the same kinds of outperformance by Growth, as a style, as we saw over 2020.

Treasury bonds, particularly longer duration bonds, performed well, as yields fell, and investment grade credit (and particularly high yield) performed poorly as spreads widened.

We are modestly underweight bonds, and our holdings are mostly sovereigns. We think credit spreads are too tight, and that “reaching for yield” is unwise at these levels, with the excess bond premium at or near zero. Depending on how far the current retracement in yields and risky assets goes, we might stretch the underweight to bonds a little further.

However, for now, they are providing a very useful portfolio hedge for our multi-asset portfolios, due to their negative correlation to equity market risk, and provide an outstanding reminder of why we hold bonds, even at low yields.

The temptation to exit bonds, in their entirety, and move up the risk curve to squeak out a slightly higher yield, is a dangerous one. The classic 60/40 portfolio is alive and well, and our comments about “underweight” are in context of a balanced portfolio that holds just under 25% (in other words a lot) of the overall portfolio weight.

Conclusion

Omicron is, simply put, highly uncertain at this stage about how dangerous it is, and what impacts it may have on the economy, and therefore on asset prices.

There are conflicting reports from medical professionals (COVID vaccine maker Moderna’s CEO thought that current vaccines might not be particularly effective, whilst Pfizer’s CEO was much more optimistic) which means caution, to us, in terms of capital deployment, and position sizing.

On net, we are underweight equities at the overall portfolio level, sitting at ~8% overweight to cash, and a sizeable overweight to Alternatives, which have a low to zero correlation to equity market risk.

In other words, we are moderately defensively positioned, which should provide good portfolio insulation if markets correct, in earnest.

Depending on valuations, we would look to selectively deploy cash during a correction.