Asset allocation update
How we're thinking about markets...
19 December 2022
The macroeconomic outlook is highly uncertain, with sharp swings in expectations as market participants adjust to new data. Trends are not clear or convincing, but it appears fears of inflation are being replaced by fears of recession. That said, whilst the data suggests economic growth is falling, many areas are showing resilience – given the uncertainties, we are not sure how long that will last. Attempting to combat inflation, policymakers have increased interest rates and reduced liquidity, which should (deliberately) reduce economic growth, and therefore inflation. The key issue for us is the extent to which economic growth is reduced in combatting inflation (e.g. how much unemployment will rise, and how much corporate earnings will fall), which will itself depend on whether inflation is now embedded in the economic system – in our view service inflation looks “sticky”, companies are struggling to attract workers so are increasing wage offers, which makes the system vulnerable to a wage price spiral, but on the other side the evidence suggests inflation in tradeable goods has probably peaked.
Interest rate & liquidity environment
Policy hawkishness is still the main feature influencing markets. The central case amongst equity and bond investors appears to be that inflation is peaking around now, presaging a peak in interest rates during 2023. However, central bankers are signalling higher rates for longer. Additionally, they are reducing their balance sheets and market liquidity which makes policy much more restrictive than headline interest rates imply, although shorter term indicators imply US dollar liquidity has bottomed and increased slightly.
Valuations & earnings outlook
World equity valuations (P/E ratio) have fallen significantly from their highs in 2021. Some areas look cheap, such as in the UK, Europe, and China, although each area has its headwinds, so the discounts are justified in our view. There is evidence that US corporate margins and earnings are beginning to come under pressure, yet they are still holding up well. Our expectation is that corporate earnings will fall from here as economies enter recession, and that this risk isn’t fully appreciated by equity investors.
Sentiment / flows
Sentiment is very poor based on survey submissions and the demand for protection in derivatives markets. Yet, in our opinion, actual investor positioning seems more ‘risk on’ with big institutional investors maintaining still high equity weightings. Perhaps the resilient earnings season is helping, and the idea that we may be near the peak in interest rates in the US.
Views by asset class
We maintained our neutral position for equities. We do expect some areas to come under pressure as recession looms, so last year we tilted our equities in the direction of both quality companies (those better able to weather an economic storm due to stronger balance sheets, wider economic moats, and greater pricing power), as well as companies that are already trading below estimated intrinsic value (so there is a margin of safety in their price).
Data in the US shows its continued strength relative to all other major economies. Unemployment is very low. Consumer and company balance sheets remain strong, earnings are holding up better than in many countries, and it has low external energy dependence, reflected in a very strong US dollar. The US remains our largest absolute equity allocation in portfolios, but we decided to hedge more of our US dollar exposure, something which has been helpful in recent months.
Within the US, smaller companies have been hit hard and are trading near all-time valuation lows, significantly cheaper than the overall market. We think they could generate excess returns and we continue to tilt portfolios in this direction.
The UK stock market is beginning to look interesting in our view. It’s incredibly cheap, and the high dividend yield is compelling. Because the pound has fallen, it’s even cheaper for foreign investors now. That said, it’s hard to see a catalyst for an improvement in investor sentiment and inflows, so we reconfirmed our low exposure to the UK stock market relative to other UK wealth managers, but we are watching for signs of a reversal of fortune.
We have been holding significantly more Japanese equity exposure than most of our competitors. Japanese stocks have performed very well year to date, largely due to the Bank of Japan’s looser monetary policy relative to the rest of the world. However, with inflation at a 40 year high in Japan, the Bank of Japan is talking of ending their ultra-loose monetary policy and yield curve control mechanisms. We think this would lead to volatility across Japanese markets, with bond yields rising across the curve and equity markets likely falling as investors reprice risk at higher rates (as they have done in the US for example). We see higher yields as a positive for the Yen, which is significantly undervalued in our view, and we decided to maintain our positive view on the Yen.
Stock markets were recently buoyed by news from China, where policymakers announced an easing of Covid control measures and a drive to vaccinate more of the elderly. However, whilst helpful short term, we are not convinced China has established the new growth model it needs so we continue to have a low exposure.
We decided to increase our exposure to US government bonds and inflation linked bonds, funded by a reduction in low-risk alternatives. Given the strength of the US dollar, we decided to invest in US bonds with the currency exposure hedged. In this way we get what we think is an attractive yield, without the currency risk.
Yields on US corporate bonds have increased to attractive levels, and we increased our exposure in the last asset allocation cycle. We decided to maintain our exposure to the asset class. Additionally, we decided to start adding to emerging market bonds, which have high yields, and should benefit if the dollar continues to weaken.
Alternative asset classes can provide protection during market falls, with returns not correlated to the rest of the portfolio. For this reason, we are still positive on the asset class, however given that government bonds are (at last) yielding something meaningful, we decided to reduce our exposure to some of our low-risk alternatives in favour of government bonds and inflation linked bonds.
We are still positive on selective macro hedge funds with an established record of doing well in volatile environments.
We view certain commodities as significantly under-supplied, with demand set to increase from the green energy transition, so we have started building a position to capture this.
Overall, the environment is characterised by high uncertainty and rising recession risk, so we remain cautiously positioned, but prepared to take advantage of opportunities that present themselves.
Summary of positioning
Below is a summary of our views for each asset class, from strongly negative (- -) to strongly positive (+ +).
Asset Class Breakdown
|Alternatives||Commodities, gold + miners||X|
|Macro hedge + other alts||X|
Investment Committee Q&A
In this feature we attempt to lift the lid on the process and our views by interviewing one of the decision-makers: David Cooke: Chief Investment Officer, Saltus Asset Management
The committee last met two months ago, what has happened since then?
At the macro level, investors have gained greater certainty over the interest rate and inflation outlook over the last two months. Recent US CPI (inflation) data has surprised positively (i.e. been lower than expectations, albeit still high in absolute terms), allowing investors to entertain the idea that we might be witnessing the ‘beginning of the end’ of the inflation issue which has dominated investment performance this year. Unfortunately, it is still very early days and the Federal Reserve is in no mood to ease up on interest rate pressure, with rates expected to climb into the New Year and then stay high for the rest of 2023. How long rates stay high is a key investment consideration for the year ahead, as it directly influences the duration and intensity of any slowdown in the key US economy.
How have Saltus portfolios been faring?
Since our last meeting portfolios have delivered positive returns, although these returns have been behind benchmark. The major reason is our exposure to UK assets, where the benefits we enjoyed from being underweight in the third quarter unwound as sterling, gilts and UK equities bounced back under a new Prime Minister. For the year as a whole and also over the last three years, portfolios remain ahead of benchmarks across risk bands.
In the last edition, our Chairman said “bigger picture, it’s still all about what the US Federal Reserve does in response to higher inflation” – can you bring us up to date on inflation and the Fed’s response? Is this still what’s driving markets?
Federal Reserve monetary policy is still the key issue for global markets. As mentioned above, recent data on inflation in the USA has been encouraging but, accompanying that, the Federal Reserve has made it abundantly clear that they will not relax the pressure until they are very sure inflation has peaked. That will, in the end, most likely result in a US recession at a point when other key economies in the world are also either entering recession (e.g. in Europe) or struggling to grow strongly due to local issues (e.g. China and its property meltdown). This combination of events makes the near term outlook particularly difficult to forecast and, even though we understand that markets anticipate recoveries before they arrive, we still think it will be a difficult environment for investing in the early part of next year.
Do you see a disconnect between Fed policy and financial markets? If you do, what are the potential implications of this?
There is a disconnect in our opinion between market expectations and Fed policy, with the market thinking that interest rates will come down quicker than Fed rhetoric implies. This may be due to differing views on how sticky inflation is or it may be because Fed overtightening causes a deep recession or ‘accident’ somewhere in the financial system. Working out how likely one scenario is compared to another is not something we have a high degree of confidence in. Instead, we would just note that market optimism leaves more room for disappointment than it does for positive surprises, making us inclined to err on the side of caution for the moment, until the macro environment becomes a little clearer.
How are corporate earnings holding up? Are there any areas starting to crack?
Earnings remain resilient but the first signs of margin compression are starting to appear. There is a record wide dispersion in strategist forecasts for where equities will finish at the end of 2023, reflecting considerable earnings uncertainty which will take some time to resolve. The forthcoming results seasons will thus be a crucial period for setting expectations for the year, although we have a feeling that since real economic slowdown has yet to bite, the true earnings picture will take much longer to reveal itself. For the moment strong energy earnings are being offset by a weaker consumer sector, leaving the rest of the market sectors yet to declare their hand.
Do you worry about parts of the economic system that could crack under pressure and affect the wider economy? Economist and investor Mohamed El-Erian points to examples such as a lack of risk management in the crypto space, the near collapse of the UK gilt market, and emerging debt crises in places like Sri Lanka, as canaries in the coal-mine, and that systemic risks aren’t being priced into markets.
This is undoubtedly a concern, and it is true to say that many market participants are waiting for something to ‘break’. Although, as described in the question there have been events in crypto, gilts and emerging markets, none of them have spilled over into wider economic or financial contagion. They do, however, reflect the difficulty some economic actors will have in coping with a world were debt is now much more expensive than it has been for many years. Given that the interest rate changes we have seen have been so rapid we think the real pain of a bigger debt burden has not yet hit the wider global economy, and for that reason alone it is fair to be worried about systemic risk and adapt portfolios accordingly.
Whether from cash rates, annuities or short-term bonds, UK investors can now get attractive returns from low-risk products – why should they remain invested in portfolios exposed to higher volatility?
As a general rule, clients should always be in portfolios that suit their financial circumstances. Over the long run we continue to believe that a well-diversified global portfolio offers the potential for returns well above cash rates, especially as some of the headline rates on offer elsewhere often come with conditions on the amount of money one can put in them, or the time for which they have to be locked up.
As we near the end of the year it’s a good time to reflect on 2022. In terms of the Saltus investment team or financial markets, what will you remember about this year? What was accomplished? What lessons were learned?
As a team we think this has been one of the most instructive and informative years we have ever worked through. The sheer variety of overlapping risks and events to be analysed, the multiple swings in sentiment and the shift into a new era of higher inflation and higher interest rates have combined to test our skills and process in a way rarely seen before. We look back with some pride that we have managed to weather the storm well in client portfolios and have achieved this in a consistent, steady fashion. Our faith in the investment process has been well founded and we think we have become better at focussing on the investment issues that matter most and speedily enacting decisions into portfolios. This should help us over the next year in an environment where we don’t expect markets to become any easier to forecast or navigate.
What are the major investment themes to watch in 2023?
Many of them are similar to the year just passed. How long it takes the Western world to get on top of its inflation issue is the key question, as it will determine how long and intense any economic slowdown will be and, hence, the shape of investments in client portfolios. Geopolitical influences will remain strong and difficult to forecast. Sentiment will remain choppy and, as a result, investor time horizons are likely to be unduly influenced by short term events. It is something we are keen to guard against as we know from experience the best long term opportunities often present themselves in periods of shorter term stress.
Asset Allocation Committee
The committee consists of several senior members of the investment team, all partners, who invest their own money alongside clients. The committee is led by:
All authors have considerable industry expertise and specific knowledge on any given topic. All pieces are reviewed by an additional qualified financial specialist to ensure objectivity and accuracy to the best of our ability. All reviewer’s qualifications are from leading industry bodies. Where possible we use primary sources to support our work. These can include white papers, government sources and data, original reports and interviews or articles from other industry experts. We also reference research from other reputable financial planning and investment management firms where appropriate.
The views expressed in this article are those of the Saltus Asset Management team. These typically relate to the core Saltus portfolios. We aim to implement our views across all Saltus strategies, but we must work within each portfolio’s specific objectives and restrictions. This means our views can be implemented more comprehensively in some mandates than others. If your funds are not within a Saltus portfolio and you would like more information, please get in touch with your adviser. Saltus Asset Management is a trading name of Saltus Partners LLP which is authorised and regulated by the Financial Conduct Authority. Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested. Tax rules may change and the value of tax reliefs depends on your individual circumstances.