Asset allocation update

In this feature we attempt to lift the lid on the process and our views by interviewing one of the decision-makers:
Andrew Fleming: Chairman of Saltus Asset Management and Asset Allocation Committee

We’ve just seen a strong rally in many stock markets. Do you think the worst has now passed for stocks? Or could there be more pain ahead?

It all depends on the inflation outlook. Risk assets have recovered from a low on 16th June in the belief that markets can see through this Federal Reserve rate hiking cycle as inflation is anticipated to peak later this year and gradually fall back towards central banks’ 2% targets.

It must be a difficult time to make asset allocation decisions, what are the key variables you are watching?

As I have observed before it’s always difficult but the current period is particularly tricky as both bonds and equities sold off together. Normally bonds rally when equities sell off. This is evidenced in the performance of a ‘typical’ industry balanced portfolio of 60/40 equities/bonds that has delivered the worst twelve month return for over 90 years. Our investment process has an established framework of assessing: macro, valuations and technicals i.e investor positioning and flows. More recently we have added an assessment of liquidity conditions. At this time we are very focussed on central bank policy and yield curves, inflation and corporate pricing power.

How likely are we to return to the Great Inflation (and associated interest rate) conditions of the 70s and 80s?

We will only get a return to 1970’s style inflation if we get a wage/price spiral developing AND central banks ‘accommodate’ through provision of excessive liquidity as described by the monetarist school of economics. There are some signs of the former developing in the US, which we are monitoring closely. Unit labour costs, for example, are up 9.5% y-o-y and a majority of businesses are looking to raise prices. The key though is that Federal Reserve monetary policy is much tighter than implied by the headline Fed Funds rate.

The bond market is telling us that both inflation and interest rates will fall next year. Do you think this is justified? What happens if the market is wrong?

The two are particularly closely linked. In this sense this period looks much more like a typical post 1945 cycle when central banks tightened to head off inflation invariably inducing a recession. We have become used to recent decades of ‘The Great Moderation’ and the Greenspan ‘put’ when the Federal Reserve loosened liquidity at the first signs of distress and inflation was subdued largely due to the emergence of China as a source of deflation in tradeable goods. We still think there is a risk of the Fed having to tighten further to head off inflation. So a risk of market complacency.

US corporate earnings appear to be holding up ok. Are you surprised by this? Do you think it will continue?

Yes, earnings and forward earnings estimates have held up very well but are starting to come down albeit slightly. The falls in equities have all been about price/earnings contraction which peaked in the mid-20s for the S&P forward earnings and fell to 15.5 x in mid-June. The reason that earnings have been so relatively strong is many quoted companies have been able to pass on higher input cost increases. In anticipation of this happening we increased weightings last year in quality companies better able to maintain margins which has been helpful.

Some assets have been hit hard this year. Do any of these now look attractive?

‘Growth’ style equities have been hit particularly hard as they are ‘long duration’ assets with earnings often well into the future. Equities with low expectations, typically ‘value’ equities, and companies seeing higher profits from higher commodity prices have performed well. If this is a relatively shallow slowdown/recession then the growth equities in areas like technology, healthcare, the green transition are attractively priced. If it is a deep recession with associated financial system distress then they will resume the falls in prices seen earlier this year. We do like, however, smaller companies particularly in the US which are looking very attractively valued.

There have been some big moves in currency markets, why is that? And how has that affected portfolios?What is your view on China? Is it investable right now?

It has all been about US $ strength. Although challenged by China the US is the World’s only super-power that controls the World’s financial system and in the Ukraine war and associated geopolitical struggle the US is very prepared to use these levers. There have been huge capital inflows into the US partly to reflect these strengths but also capital flight from regimes where the rule of law is poor and the fact that the US Fed was the first major central bank to raise interest rates. In addition, the US is a remarkably resilient, adaptable capitalist economy with corporations that have a tremendous record of productivity improvement and innovation. The yen has been particularly weak and we are partly reducing our successful hedges here.

Regarding natural gas, are you worried about what will happen in the UK and Europe as we head into winter?

Europe is particularly vulnerable, and US self-sufficiency just adds to the US$’s appeal. There has to be a high probability Russia will turn off the gas taps which will make it a very difficult winter for households and businesses particularly in Germany and Italy. Enormous efforts are being made, however, to find alternative supplies and improve the LNG infrastructure. A European recession is very likely but largely already reflected in financial markets.

Do you think Europe will blink and reduce sanctions on Russia?

Holding the EU coalition together won’t be easy but there is enormous pressure, particularly from the US, to maintain solidarity. Italian politics is a particular risk given Italy’s dependence on Russian gas and oil.

What role does gold play in our portfolios?

Gold has the enviable position of being a consistent performer during market drawdowns. Over the worst 30 months for equity markets from the last 30 years, gold has averaged a return of +1%, while the MSCI World has fallen on average -8.8%. For clients with lower risk tolerances, gold remains a strong investment to pair with equities to generate better risk adjusted returns. That said, we don’t aim to hold a fixed allocation, rather we increase our exposure when fundamentals and valuations look appealing and dial it back when the inverse is true.