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 the Asset Allocation Committee

The committee last met two months ago, what has happened since then?

The last two months have seen a general continuation of the rally in riskier assets which started in early October. Equities have moved higher as have corporate bonds. This trend has been confirmed within markets, with cyclical sectors generally outperforming more ‘defensive’ ones. Although we have positioned portfolios slightly under their neutral risk positions, we have generally kept up with the recovery through allocations to smaller capitalisation and higher quality equities, which have performed well.

What is the Committee's view on inflation?

We have been very consistent in highlighting that markets are all about the macro environment in general and inflation in particular. So far, the inflation ‘shock’ - and we need to recall that US consumer price inflation was close to zero as recently as 2020 - has focused on the actions of central banks to tighten policy to bring inflation down and prevent a 1970s inflation surge. So far, companies have managed to maintain margins and profits well in the face of higher interest rates, which is why equities haven’t fallen more than they have done. We are concerned though that the next phase of inflation will potentially threaten consumers' ability to spend, as wage rates are coming in well below inflation.

China has removed many of its covid restrictions, how significant is that for investors?

The Chinese economy has recovered in the same way most other economies ‘bounced’ after covid restrictions were lifted. This has been supported by the central bank’s very significant liquidity injections. Chinese equities have recovered strongly. We remain cautious on Chinese assets as we can’t identify a new growth model, but the liquidity creation is very helpful for trade and wider emerging markets and commodities.

Is global growth still slowing? Do you think we will see recessions, and if so, how severe are they likely to be in your view?

Our road map for this cycle has been clear for some time. We have been on ‘recession watch’ for nearly eighteen months, which is why we have been running a value and particularly quality bias in equities, which continue to serve clients well. The key issue remains whether central banks will need to raise interest rates more than currently anticipated, effectively inducing a recession to squeeze out the inflation threat. The shape of the US $ yield curve, which has now been steeply inverted i.e. longer rates are well below short rates, has in the past been a reliable indicator of recession. We are less convinced, as we believe there is in this cycle strong demand for longer dated high quality US government bonds, as there is a shortage of higher quality collateral to hedge futures and swap positions.

How are corporate profits holding up?

As before corporate profits have held up well in the face of higher input costs as a result of inflation and higher interest rates. The risk now is that consumption weakens as real incomes are eroded by inflation. In the USA, labour markets are strong, as is consumption. We think there are risks to both of these trends: corporations raised huge amounts of low interest rate debt in the 2018-22 period, so many are less exposed to higher short term rates, however, they will have to start refinancing in the coming period and there is still an overhang of excess savings from the covid lockdown periods that is boosting consumption, but is being eroded. There are two sectors we are particularly alert to profits risk: financials, given the shape of the yield curve and property, particularly given the likely costs of upgrading energy efficiency ratings over the coming decade.

Economic data seems hard to read at the moment, often with conflicting signals, what are the key things our Asset Allocation Committee is looking for?

Without wanting to sound complacent, we have read this cycle reasonably well so far, but there is huge uncertainty as to how it now plays out, with a wide range of potential outcomes with equally wide implications for markets. Overlaying everything is historically high debt to GDP ratios, which makes all the moving parts of a highly complex economy and central bank policy actions so difficult to read.

In periods of high volatility, sometimes great opportunities present themselves. Do any asset classes look particularly attractive in your view?

Markets are currently not particularly volatile, as they believe the US Federal Reserve can engineer a reduction in inflation without a hard landing recession. We think there is some complacency and, in the short-term, volatility may increase again as most of the hedge funds have closed out ‘short’ positions in equities.

How do Saltus manage currency risk in portfolios?

We don’t try to ‘manage’ currencies. Instead, I would describe our approach as being currency ’aware’, based on a valuation framework leaning into and out of emphasis, particularly as global investors against a client sterling currency base. If I can illustrate the point by describing how we deliberately allocated to US assets in the last two years as we thought the £ would weaken. Since the end of last year, we have thought the US $ would be more likely to weaken, so took an opportunity at an attractive entry point to switch our bond holdings to currency hedged share classes, which has been helpful as sterling recovered.

What lessons can be learned from history for how to interpret what's happening right now, and how best to manage portfolios in this environment?

I have been very consistent in saying this is a very different cycle to any seen in the last thirty years, which is the experience of most market participants. To me it looks much more like a 1945-2000 period cycle which was characterised by central banks having to tighten policy invariably inducing recessions to head off inflation. There is this central risk in this cycle, but to my mind it is immensely more complicated by the much higher debt levels mentioned earlier, the associated very high levels of house prices in most ‘western’ countries, all overlain with the growing geo-strategic hegemonic rivalry between the US-led world and China. There is clearly lots to worry about, but there is also a big risk to my mind that investors are still ‘anchored’ in a low interest rate/inflation world where ‘real’ interest rates are effectively the same as nominal interest rates. At current inflation rates, there is a real risk of inflation really eroding the real value of cash-like savings. There is a strong case for believing inflation in the next thirty years will be higher than the last thirty, which means investors will need to be careful to get exposure to real assets, like equities, with a history of protecting real inflation adjusted value over a cycle. The encouraging thing at the moment, to finish on a slightly more encouraging note, is we can see the early signs of a new central bank liquidity cycle into next year, even if the current environment is very uncertain.