Asset allocation update How we're thinking about markets...

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.