Trades

Recently (ish) we bought a modest amount of small cap (both international as well as domestic), emerging market equities, property and infrastructure, funded by selling down some alternatives.

That (recentish) positive inflation print out of the US was, we think, a catalyst for a small trade, at the time.

Small cap stocks don’t have the scale or bargaining power of large caps, and they can be “hurt more” by rate rises. Similarly, inflation’s impact on margin; it’s harder to pass through costs to your customers and suppliers when you are not enormous or systemically relevant.

Emerging markets particularly don’t like high interest rates, especially high US interest rates, where it impacts loans in hard currency.

Property and infrastructure are duration sensitive, and we’ve talked about them a lot.

All 4 have been clobbered, relative to large cap developed equities, underperforming by a very large margin.

And so, we’ve topped some of those up. Still at/or-slightly-below our below our SAA weight for smalls and EM, and our SAA stating weight to both is quite modest in an absolute sense. Some funds are happy to take the EM up to 7-8-9% of an overall balanced portfolio, we’d probably need Armaggedon to do that. Even infrastructure; some of our peers will run to 12-15% via unlisted infrastructure, we will likely not.

Now, that collection of trades might have been “too soon”. Perhaps the great inflation print (an annualised rate only a touch above 2%, the pre-pandmic level) out of the US was because things are falling apart, as opposed to “cooling nicely, ala Goldilocks”.

And if things are not just cooling but icing over than it is unlikely that small cap and the EM region do well. However, if it was the “hard landing” angle, I think our bond portfolio allocations would perform well, and we can go and buy cheaper equities in aggregate again.

The worry remains that we get headfaked, as we have been at least twice now, by what looks like easing inflation, easing labour markets, easing economic activity, only to find it accelerating again, which requires “more beatings” from tighter policy.

In which case the carry on bonds is nice but probably inadequate, and modest negative capital losses produce a sub-inflation total return on the bond portfolio, and of course the stocks themselves probably don’t do all that well if there’s no rates relief, and tight labour markets produce the kind of wages growth that eats into margins.

There’s no firm conclusion here. The broad probabilities are much as they’ve been for 18 months now (a very long time, it feels like) in that we either get a soft landing, a hard landing, or no landing, with no landing swiftly becoming a hard landing in any case (so really just the two options, but a different path to getting there).

The world usually muddles through, and you do want to be on Team “growth for the long run”, even as it means you might have to be prepared to average down into subsequently cheaper units.

NB: the use of Alts and cash to fund the trades was largely because we think Alts have done a great job (equity market neutral strategies, for example) of helping insulate the portfolio from drawdowns across stocks and bonds, and can now be monetised in part to get set in cheaper, more straightforward options that have solid ex-ante return prospects.

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