So the Fed hiked, by 50bps, which by this late stage nearly everyone knew or thought would happen.
Powell was neither dovish nor hawkish, in our view, reminding everyone it is too soon to declare victory over inflation, but, that said, things were headed in the right direction.
There is a gap between the market expectations, and the Fed, in which the market thinks rates will be cut over 2023-2024, whist the Fed’s projections suggest that rates will peak, but remain largely on hold, over that period.
Our view: “still don’t fight the Fed”.
Here’s where we struggle, chasing our tails in terms of thinking.
Nearly every single professional economist, and most sell side strategists, expect a recession.
However, if so, it is the most anticipated recession in history. Surely, then, it is in the price of assets.
Again however, simply eyeballing stock market drawdowns over recessions, suggests that the peak to trough drawdown would be at least c15% lower from here.
So, if the market is pricing in a recession, it’s got to be amongst the most mild of mild recessions.
It is also the case that circumstances matter.
The US having a mild recession is one thing, but, the emerging markets are having quite a bag of troubles with debt servicing, forex pressures, inflation, and commodity prices.
China is currently under extreme pressure, as the property sector corrects.
Europe is similarly fighting the inflation, energy, and geopolitical risks.
If the US slows it seems reasonable to assume some additional negative spill-overs to these other countries.
What that means is the distribution of risks in the left tail is harder than usual to parse.
In other words, the median expectation is recession, but, assuming that happens, how quickly things could go “non-linear” (maybe just “exponentially worse”) isn’t clear to me.
Then we have debt dynamics in places like Australia. Mortgage costs have more than doubled, at the margin, and household debt is enormously elevated.
This looks highly problematic, and to me, looks exactly like the US in 2006.
So, what to do there?
Maybe trying to flip the problem around on its head would help.
What happens if we just plain old muddle through? We get the soft landing. Supply chains continue the unwinding that we’ve already seen, and weaker inflation means stronger real wages which supports consumption and the economy hits a purple patch of good performance.
Well, now we are just back to weighting our “soft landing” vs “hard landing” vs “stagflation”. We’ll wish we had more shares in the portfolio, more risk on, but it isn’t going to make a massive difference to total return. Is the potential extra bit of alpha worth it, in a risk adjusted return sense? Maybe. I’m not sure.
The best we’ve got is to stick close enough to the SAA weights. There’s plenty of good reason to deploy capital, and plenty of reason not to overcommit to anything.
Let me now plagiarise from Howard Marks (Oaktree) who has issued another one of his big investor letters recently.
Here’s what he wrote as his 2016 guideposts for investing in a low rate low return world.
Now we are in 2022, but the second bullet point, and the fourth bullet point, are the ones in contention here.
We are sticking close enough to our portfolios SAA, realising that we are giving up some return, in order to keep the risks well distributed, and to preserve firepower in the event that the path to the soft landing proves difficult.
We will still make good money, very likely delivering on the SAA objectives (e.g. CPI + X, and, hopefully above the median manager, although I’m not too worried about that second one relative to the first one) with the positions that we have.
Global growth slowing, and the Fed tightening, and intending to remain tight, is probably the lens you have to take if your mantra/investment proposition/value proposition to clients is “protect and grow wealth”.
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