A Prolonged Period of Tension and Change

Many of the structural trends that we have talked about in previous quarters gathered momentum over the last couple of months. The military conflict in Ukraine has remained intense. Ukraine launched a successful counter-offensive against Russia in September which enabled it to take back some territory in the Donbas region. The heavy losses sustained by Russia, estimated by Western experts at around 80,000 casualties since the start of the war, led President Vladimir Putin to call up 300,000 reservists. Sadly, it appears that the war will be drawn out with little prospect of peace negotiations in the near term.

Elsewhere, geopolitical tensions escalated in the Asia-Pacific region as US House of Representatives Speaker Nancy Pelosi followed through on her controversial trip to Taiwan in early August, making her the most prominent US politician to visit Taiwan in 25 years. China responded with a week of intense military exercises around the island, including incursions across the median maritime line and missile tests directly over the island. US President Joe Biden has now on multiple occasions repeated his promise that the US will defend Taiwan, putting an unofficial end to the decades-long US policy of strategic ambiguity.

Such events provide further confirmation that we are now in a multi-polar world, as highlighted by our great power competition theme, with the US, China and Russia heading for a prolonged period of high tensions. More uncertainty and greater volatility are likely to be the result.

Growing geopolitical tensions are likely to further accelerate the trends of deglobalization and ‘friend shoring’ – the manufacturing and sourcing of components and raw materials within a group of countries with shared values. We are seeing a shift from ‘efficiency economics’ to ‘resilience economics’, as Western economies look to make significant investments in strategic areas such as food, energy and defense, with a lower priority being attributed to cost and achieving maximum efficiency. The trend began with former US President Donald Trump’s ‘America First’ policies, and has been accelerated by the Covid-19 pandemic and most recently the war in Ukraine.

Multinational companies that embraced globalization may be stuck in the middle, with significant impact on their supply chains, capital-expenditure requirements, and profit margins. For many businesses, moving from ‘just-in-time’ to ‘just-in-case’ inventory management could be a dominant theme.

These shifts, combined with chronic underinvestment in ‘old economy’-style businesses (which has led to serious supply shortages in many areas), is likely to require a steep recovery in capital expenditure in many industries. Over the last 15 years, cheap money has flooded into areas such as technology, but few were interested in capital expenditure-intensive businesses and commodity producers. Supply-chain bottlenecks and supply-demand imbalances are likely to prompt a change.

The green-energy transition is another area that may require additional spending. Higher corporate capital expenditure, together with increased government spending and fiscal stimulus, has the potential to bring higher growth, higher inflation and higher interest rates across the curve.

Asset-Price Deflation in a Higher Interest-Rate Environment

Does this spoil the party for risk assets? This seems highly probable, with expected returns set to be lower after an already challenging period. Meanwhile, central banks have lost their flexibility to elongate the business cycle.

To explain why, it is worth providing some historical context. Over the last four decades, we have become used to long business cycles. This is because there has been an extended disinflation trade, and every time there has been some form of economic slowdown or crisis, policymakers have had the ability to loosen policy through lowering rates, as inflation was not a problem. This policy stimulus had the result of extending economic cycles. The last 40 years cover the careers of virtually everyone working in the financial industry, and therefore collectively we have been conditioned to believe that a business cycle in the US lasts for seven to ten years, while the most recent one has been even longer at over ten years. History, however, shows that economic cycles tend to be considerably shorter.

Even more importantly, policymakers have traditionally found it more difficult to intervene when their policy flexibility has been limited. We are now moving back into such an environment, where flexibility has become more restricted owing to high inflation. If inflation remains sticky, it will be difficult for the US Federal Reserve (Fed) to come in with its ‘put’ and extend the cycle for as long as most of us have been used to in our careers.

In this context, the years of falling inflation and low interest rates that were a powerful tailwind to asset prices are likely to have come to an end. The starting point today is a lot less favorable than it was at the start of the ‘Great Moderation’ in the mid-1980s, after the global financial crisis in 2009, or in the aftermath of the Covid-19 pandemic in 2020. Profit margins are elevated, valuations are stretched, and policymakers have no choice but to increase policy rates to fight inflation. We are therefore likely to reset in an environment with lower equity-market returns, higher volatility, and shorter boom/bust cycles.

In such an environment, we think traditional asset-diversification strategies are unlikely to work as well as before, and active, flexible approaches will be better suited to navigate the many challenges facing investors.

The UK Example: Higher Growth at Any Cost

The fiscal activism that we are seeing from the UK government is an unorthodox response in a high-inflation environment. Fiscal austerity and the desire to regain control of deficits seem to have been consigned to the past, with policymakers firmly believing that greater focus is required on promoting economic growth. The perceived solution to structural problems is to increase the fiscal deficit and, if necessary, finance it by expanding the central bank’s balance sheet.

However, spending money that we don’t have has consequences. Aggressively expanding the fiscal deficit at a time of rapid inflation and tight labor markets, and while the central bank is tightening monetary policy, may be considered brave. Sterling, which sunk to a record low against the US dollar in September, is bearing the brunt at the time of writing. Time will tell if these policies work, but either way, the shift towards looser fiscal policy, combined with tighter monetary policy, is a toxic combination for investors. Investment returns look set to suffer.

The Japanese Experiment – Careful What You Wish For

It is perplexing that while most developed-market central banks have been fighting inflation, the Bank of Japan (BoJ) has stood its ground on keeping interest rates at rock bottom to support the economy and generate higher – and, in the words of Governor Haruhiko Kuroda, “stable” – inflation.

Gate, Torii, Building

Such a policy appears to create more questions than answers. It is possible to control yields, but without capital controls, the currency tends to act as a relief valve (i.e. the currency takes the pain). A stubborn commitment by the BoJ to its yield-curve control policy is therefore causing a collapse of the yen. As long as US bond yields are rising, which they have been doing, and if the BoJ is trying to maintain its 0.25% yield target on the 10-year Japanese government bond, the yen appears certain to continue to depreciate.

In the current environment, the BoJ will need to buy an ever-increasing amount of government bonds to keep the 10-year yield from rising; this, in turn, is likely to destabilize the yen, and currency weakness will then lead to more imported inflation. However, Japanese households may have very little in the way of salary increases to compensate for it. It is therefore hard to see how any economic gain will be realized.

Recent price action has created an impression of loss of control and policy chaos. It will be interesting to see what happens if inflation rises from, say, 3% to 4% and then 5% in Japan. Will it be possible to maintain yield-curve control without a loss of confidence in the currency? Japan could end up with too much undesired imported inflation or hyperinflation, instead of the “stable” form desired by its central bank.

China Slowdown

China’s domestic economy remained heavily constrained over the summer by the government’s continuing zero-Covid policy, which at times saw up to 15% of the nation’s economy under some form of lockdown. China’s domestic consumption, as seen in the government’s monthly retail sales print, remains heavily subdued.

The Chinese government has been preparing for the all-important 20th National Congress which will begin in mid-October and see the appointment of new senior Communist party members, as well as confirm President Xi Jinping’s appointment for a historic third term.

With sentiment around China’s economy and equity market at very depressed levels, there may be scope for some relief after October with new senior members of the party installed, a lightening of the regulatory burden, some additional stimulus and an eventual relaxation of Covid restrictions. However, a return to pre-Covid levels of economic growth seems less likely owing to the global macroeconomic backdrop, technology restrictions, and a property sector downturn which is proving difficult to turn around.

The US Earnings and Growth Scare Has Barely Started

In the US, important indicators in the manufacturing and goods sectors are likely to hit recession-like levels during the fourth quarter. This will coincide with an earnings downgrade cycle that is only just starting. This has not yet been fully priced in by the market, nor has the fact that this time the Fed is unlikely to come to the market’s rescue. This is the first business cycle in 40 years for which the Fed’s top priority has not been to avoid recession but to fight inflation. Fed Chair Jay Powell has even noted that there is a willingness to tolerate below-trend growth. The goal appears to be to bring the labor market back into balance by creating slack for a while.

Will the Fed be able to engineer a soft landing? History is not on its side. Soft landings have previously proved hard to achieve; on each of the last five occasions when inflation peaked above 5% (in 1970, 1974, 1980, 1990 and 2008), the consequent tightening cycle was followed by recession. The Fed is focusing on backward-looking indicators such as employment and inflation measures, and by the time these indicators turn, the economy may already be on a downward trajectory that is hard to reverse.

The US may already be experiencing a significant slowdown that has not yet showed up in unemployment and inflation figures. Housing, for example, which is an interest rate-sensitive sector and leading indicator, is clearly weakening, as indicated by a declining National Association of Home Builders housing market index, and falls in housing permits, meeting appointments, and existing home sales. Recession appears likely to follow, but how deep that recession will be remains unclear.

The Inevitable

Major central banks are acting decisively in the fight against inflation, and the risk of recession is rising. Not all regions are on the same trajectory, with Japan and China being two obvious exceptions, although both face their own unique circumstances.

Elsewhere, central-bank hawkishness is becoming aggressive, while the impact of quantitative-tightening programs, which reduce central banks’ balance sheets, is yet to be felt. When the Fed buys securities through quantitative easing, it credits the seller’s bank account with the funds while simultaneously crediting the bank’s account at the Fed with reserves. Through this process, the capital of the commercial banking system increases, thus easing financial conditions. By ceasing to reinvest the proceeds of its bond portfolio, the process reverses, leading to fewer reserves in the system and tighter liquidity conditions. It is much easier for asset markets to cope with downturns if the Fed is easing, but much less so if the Fed maintains tight policy as growth slows.

Historically, US recessions have always been accompanied by declines in corporate profits. Recession is probably not fully in the price of most markets, with equities in particular unlikely to have fully accounted for an earnings downgrade cycle that has barely started. Nevertheless, while there will be choppy waters ahead, and with market volatility likely to remain elevated, we could be approaching the point of maximum pain where opportunities to invest for the long term become plentiful.

The refrain of the last four decades has been that everything went up pretty much all the time, and if there was a dip it was a buying opportunity. That approach may not work this time, and investing might be a lot more complicated than before. In our view, such an environment is ripe for active investors. In equities, stock selection is likely to be important, with a focus on companies that are best placed to withstand what could be a very challenging period over the next few years. Meanwhile, flexible multi-asset approaches that can quickly respond and adjust risk exposure and asset-class mix to suit the most attractive opportunity set, with the potential to generate a decent long-term return with lower volatility, could be highly relevant.

Assets such as shorter-dated government bonds and gold may do well in this environment – the former as a ‘buy and hold’ strategy offering an attractive yield, while the latter is a real asset alternative to fiat currencies, and cannot easily be manipulated. Elsewhere, gold has the potential to serve as a buffer against geopolitical risks and fiat money debasement, which are front and center of investors’ minds given the current backdrop. In summary, despite the environment being challenging, we believe it is not devoid of opportunities for active managers.

Investment thoughts from our Real Return team - Oct 2022

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