For more than a year and a half we have held mostly our highest allowed level of equity and high yield risk across our strategies. In late February, we then reduced risk in two steps in order to hold defensive portfolios while market risk was unusually high. The reason, as captured in our algorithms and illustrated in Figure 1, was that financial market risk was getting precariously close to spiralling out of control.
Mounting losses in USD bonds of Chinese real-estate developers has increased the fear of a Chinese and possibly a global downturn. The uncertainty created by mistakes in central bank communications and policy, and the Chinese policy of forcing markets to re-align to its own policy goals, was amplified by the inflation and security shock created by Putin’s invasion of Ukraine. As seen in Figure 1, the Nasdaq index entered a bear market, EMU equities declined sharply, and Chinese equities listed in both the US and in Hong Kong seemed to be entering a free fall.
Figure 1: The global equity market correction almost spiralled out of control in 2022
The risk picture and therefore the risk-return outlook has benefited from several tangible improvements, but also some more intentional and aspirational declarations. As calm has re-appeared, we have now re-established some of our equity and high yield positions, moving from “Defensive” to “Balanced” portfolio positions across our strategies. For a multi-asset strategy, this means we have been adding 30%-45% equities and where applicable typically 20%-30% high yield bonds. In our global fixed income opportunities strategies, we have added 50%-60% high yield bonds, financed from government bonds. The main improvement can be summarised as follows:
- In China, The Financial Stability and Development Committee stated that “Continuing economic development is the first priority of the Chinese Communist party”, that Covid restrictions will take economic growth into consideration, that clear rules for platform companies will be established, and that the Chinese authorities will also work with their American counterparts on a framework agreement for Chinese companies to be listed in the US in the future.
- For central banks, Putin’s war and the associated sanctions offer an excuse for letting inflation run higher and longer. A further loss of credibility of central banks would create a problem not only for government bonds but also for all other valuations across financial markets.
- In this context the FOMC used its recent meeting to re-establish some credibility by communicating that rate will go up and that the timing of the steps will be as required, which means that both 25bps and 50bps hikes are under consideration and also that they expect that a level of approximately 2.4% will be enough to cool the economy. A reasonable assumption given how much mortgage rates have increased.
- Across the world, and in Europe in particular, a significant increase in investment can be expected because everyone now realizes that dependence on Russian energy is a doubtful proposition. In most countries, such investment may be combined with the ongoing transition to a sustainable future which hopefully will accelerate.
- Renewed spikes in energy prices and limited availability of some commodities will lead to higher short term inflationary pressures. Increased demand from the energy transition and defence spending will increase the demand for investments and thereby also inflation. In combination, the real economic and inflationary process will lead to higher nominal growth.
- Some of these investments will be financed via budget deficits. Others, especially in the EU, are likely to be supported by supranational transfers in the form either of loans or grants as part of support packages across the EU. This has already been advocated by many politicians, including former ECB president Draghi in his current role as Italian Prime minister.
The communication of the Fed and its effect on interest rates is the most visible of the above. It is important to note in this context that not every spike in inflation will lead to a situation such as in the early 1970’s, when inflation spiked, and equities fell as a recession hit the US economy because of the oil price shock. As highlighted by the Fed, not all increases in inflation occur in the same manner and some do not lead to recessions but rather to gradual moderations in price increases. As this message has sunk in, yields have increased, and the market is now broadly aligned with the Fed in expecting a long series of rate hikes towards the 2-3% range. This repricing has removed one immediate risk.
Another less tangible but potentially very important factor is Chinese politics, both at home and abroad. The issue of Putin’s invasion of Ukraine have been left out of most economic and market related communications from China. Politically, the Chinese have stuck to the message that the war is not something they like to see. This makes sense from a Chinese perspective, because Xi does not like the idea of losing prestige due to his declared friendship with Putin. But China will try to benefit from the trade opportunity arising from increased Russian isolation. The friendly relationship and the potential sanctions that an extension of support for Putin could lead to almost killed the Chinese equity market. What had started as a clamp down on platform companies, and in particular on Ant financial, spread to a country-wide phenomenon with the melt down of USD denominated high yield bonds related to the construction sector. In early March, it developed into what looked like outright panic selling of Nasdaq and Hang Seng listed Chinese stocks. In as in this context, the Financial Stability and Development Committee called an emergency meeting and declared that the Chinese Communist Party sees stable economic growth as their main target. Additionally, it was explicitly announced that Covid restrictions would in future take economic growth into consideration, that clear rules for platform companies would be established, and the Chinese authorities would work with their American counterparts on a framework agreement for Chinese companies to be listed in the US in the future.
These statements turned around market sentiment and Chinese equities made remarkable rebounds (from equally remarkable lows). Although there was no mention of Putin’s current or future wars, Chinese companies clearly cannot expect to remain or become listed in New York while the country is providing weapons for Putin to use against civilians in a war that breaks with the idea of the indisputable
boundaries of sovereign states and other principles dear to China.
After about a month with reduced risk we are now re-establishing positions and moving from our “Defensive” portfolio allocations to a “Balanced” positioning. This step is likely to be followed by a move to “Positive positioning” should the improvement in conditions continue. For the time being, our views can be summarised as follows:
- The Federal Reserve has begun the work of re-establishing its credibility and has laid the framework for an expected tightening of their monetary policy, which has already been priced into the US fixed income market.
- The large-scale changes in the business environment, and the associated collapse of the property sector in China, led to a sharp economic slowdown in 2021. It is now the Chinese Communist Party’s priority to restore growth and collaborate with the west on financial market issues. And in China the party decides.
- A lot of the fear of a collapse in the companies and sectors representing the newest global tech phenomenon have been priced out both in China and globally. This risk of a further collapse is therefore no longer eating into investor sentiment to the same degree.
- US and European high yield default rates are low and we expect them to remain that way over the foreseeable future. A widening of credit spreads has been generally prevalent. With more clarity from the Fed, we expect yields to calm down and spreads to tighten again. This would directly feed a more positive reading of our credit algorithms, which currently send the most negative signal possible.
- For a typical balanced strategy, this means a move to 30%-50% equities from 10%-15%, and in our systematic allocation strategies from holdings of zero to 25% up to 60%-70%.
- In our global fixed income opportunities portfolios, we have increased the high yield allocation
from 10%-15% to 60-70%. This time we are holding an even larger weight in short duration US
We are now starting to rebuild positions in order to capture the upside of what we believe will be a world of higher nominal growth than before the pandemic. It is also a world where both equities and bonds are risky, and as we see more upside in equities and high yield than in government bonds and corporate investment grade credit we are positioning accordingly.