Credit spreads, equity premia and markets

A lot of models are flashing red for recession. Term spreads (2s-10s, probit models augmented with FCI or oil), or models that weight macro data like confidence or PMIs more heavily.

Here’s another, with augmented credit spreads implying a steadily rising recession outlook.

Interesting that, for the most part, forward earnings (BF12) haven’t rolled yet. European energy crisis, strong dollar, global growth slow down (as a function of the first two) has seen stocks roll, but not the underlying earnings.

In our view, it is simply a very challenging macro backdrop to navigate.

We’ve been reducing our Australian share exposures, predicated on the above macro concerns, but also given a) Aussie market is a “risk on” market, essentially a higher beta trade than many other markets, and b) has performed well given strong commodity prices, which makes locking in relative performance attractive.

We’ve been letting the cash in the portfolio rise, and although we are tempted to add to our fixed income holdings, we will wait for the RBA to keep tightening, and to see if we can reinvest in AGB 10s with a 4 handle, even as the curve flattens.

We’ve got enough bonds that if we never get back to 4 and a recession does take hold, those defensive assets should do well enough regardless.

The flip side of all these considerations is that if the soft landing scenario comes through, stocks and credit should do quite well, and the starting point for valuations is quite attractive. Equity risk premia are generally at or above historical averages, and really the number one fear we have as asset allocators is having the market compound away from us without enough risk on the table.

We don’t want a Grantham GMO-type situation in which one cries bearish for so long that the eventual underperformance is impossible to claw back (he was in the AFR again, quoting doom and super-bubbles, much as he has done for over a decade now).

A good compromise leaves everyone feeling a little dissatisfied. Diversified portfolios are the same. You either had too much risk, or too little, depending on the day, the week, or the month’s trading. And that’s the point; if it all goes up simultaneously, there are likely too many correlated risks in the book.

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