It is that time of the year when we, as market watchers, pull out our crystal balls. Just as we dust ourselves off from the past year, we look to the one ahead, either with anticipation or trepidation.
Taking a moment to look back, it has been an extraordinary year – from the tremendous gains from a handful of stocks to a synchronous increase in interest rates from Central Banks to whiplash from the bond markets. Given that towards the beginning of the year recession was the only alternative, most investors have been surprised by the resilience of developed market economies, despite persistent inflation, but buoyed by better-than-expected unemployment numbers and wage growth.
Although the cost-of-living crisis continued apace, consumers, so far, have been surprisingly resilient in the face of sustained pressure on household finances from inflation and high interest rates. This has flowed through the developed market economies, especially in the US, leading to stellar growth, with the Eurozone and UK lagging behind. Though we near the end of the year with thoughts of a well-engineered ‘soft landing’ by central banks, the situation remains far from clear – with numerous alternatives to be considered.
From a macro-economic perspective, we now enter a period of change. Since 1980 till last year, we have been in a world where interest rates have declined. More so, since the Financial Crisis of 2008, we have been through a period of low economic volatility, low inflation and low rates but high realised returns. There now appears to be a change in the wind.
We are at levels of interest rates last seen before the financial crisis, but even more challenging has been the speed with which Central Banks have ratcheted up rates. Naturally, this has caused volatility in markets – but what has been unnatural has been the fact that while volatility in equity markets has dropped, fixed income volatility has remained elevated as can be seen in Figure 1. This has wreaked havoc with low-risk portfolios which have been, traditionally, heavy in fixed income. If there is one certainty that we can speak about, it is that volatility will be our constant companion for the coming year. Were it to be constant, volatility in and as of itself would not pose a problem – it is expected that the volatility of volatility will be high, creating peaks and troughs in volatility levels.
Although inflation has declined over the recent past, the effect of the change in monetary policy is yet to be fully understood. Milton Friedman said monetary policy acts with ‘long and variable lags’. The economic resilience of the past year can partially be attributed to savings of households from the different pandemic related stimuli, as well as widening government deficits. As the level of savings decline, faced with the real reduction in disposable income (Figure 2) from the cost-of-living issues, one can expect a deterioration in consumer demand, resulting in lower growth.
This can already be seen feeding into consumer and business confidence, which are considered lead indicators of economic activity. High interest rates also affect corporates. Taking advantage of the low interest rates, most corporates increased the amount and maturity of their borrowings. This can be observed from credit spreads, which have not followed their usual widening pattern, following interest rate increases. As a result, the corporate default environment has been very benign. However, when time comes for refinancing, these companies may be faced with an increased cost of capital, which may materially alter the corporate bond market. It has only been about three quarters where the high base rates have had an opportunity to reset and have impacted company cash flows. This has resulted in a reduction of free cash flows for numerous business which have borrowings which are not aligned to maturity structure of their assets, be it tangible or non-tangible. The need for refinancing capital may make some capital structures put in place inappropriate and unreliable.
One may look back at equity markets globally and would be hard pressed to complain. However, one takeaway has been that diversification did not pay – Figure 3 shows a wide disparity between Growth and Value stocks. An equally weighted holding in the ‘Magnificent Seven’ stocks doubled in value over the recent year, while the S&P 500 gained circa 20%. This has resulted in the weight of these stocks in the S&P Index to be around 29%.
In relative terms, while growth assets did very well, defensive assets like bonds lagged. While this is not abnormal in late cycle dynamics, the egregiousness of outperformance is. This is not expected to continue going forward as cyclical pains appear to have been delayed and not eliminated outright – a typical scenario where the can has been kicked firmly down the road. While valuations in Large Cap equities appear to be stretched, the same cannot be said for Mid or Small Cap stocks. These stocks are typically more influenced by local economies rather than the more global Large Cap stocks and as a result, seem to have factored in the recession probabilities to a larger extent. As a result, one could possibly expect a rotation into stocks lower down the capitalisation ladder – which may expose portfolios to greater drawdown risks as liquidity gradually dwindles in these markets, as fiscal tightening takes hold.
China, which has recently been the driver of global economic growth, has been impacted by structural issues stemming from the real estate sector. The sector has been a driver of growth in China, with it accounting for almost half the local government revenues. The recent well documented wobbles in the sector exposed the reliance of China’s financial and government sectors on real estate and its associated infrastructure development. The administration has ruled out blanket bailouts in favour of ‘remodelling’ the debt-stricken sector to further extend support to the ‘stronger’ developers whose bankruptcies could trigger wider financial contagion by encouraging bank lending, bond issuance and equity financing. The overall aim is to reduce the reliance on this sector, while maintaining a sizeable presence.
One must remember that China is a developing economy in transition from a primarily export and manufacturing oriented one to a consumer driven one. This transition is not easy given the trade restrictions in place from developed economies and the simmering tensions between itself and the developed world, primarily led by the US. If the transition is well managed and the market stabilizes, the economy will continue to grow and fuel global growth, but the path may be painful for all involved.
To cap it all, geopolitical risk is back on the horizon. While the Ukrainian war rumbles on, the Middle East is embroiled in further violence. While Europe has more or less weaned itself off Russian gas, uncertainty in the biggest oil producing region could risk creating stickier inflation through higher oil prices and potentially weighing on global asset prices. This would have a greater impact on Europe rather than US, given the latter has a larger domestic production base. Upcoming elections in the US, UK and India also creates an overhang of possibilities of global tension and uncertainty, already exacerbated in a polarised world.
To conclude, two words would define the outlook for the coming year – ‘cautious’ and ‘selective’. To give a twist to the old adage, if we manage to take care of the risks, the returns will take care of themselves. A successful navigation of the upcoming year will depend on how cautious we are in our approach and how selective we are of the risks we include within our allocations. It is clearly a case of keeping dry powder, which will be instrumental in taking advantage of material opportunities which will definitely arise once the markets readjust to the new regime.
Hear more from Abhi Chatterjee, on the Chief Investment Officer Panel, at March’s Dynamic Planner Conference.