A DABB market (Difficult alpha and bad beta)
The big market themes are mostly negative for beta returns. Unlike in the global financial crisis or COVID periods, policy is also working against investors. Higher inflation is bad for most bonds and threatens equity returns through reduced margins. So defensiveness and alpha strategies are the mitigants to markets under pressure. In the short-term, however, a peak in the year-on-year inflation rate, some stabilization in the rate outlook and a decent Q1 earnings season should help. Beyond that though, returns will struggle as we get through to the end of this economic cycle.
This time of year it should all be about re-birth and optimism. At the moment, however, it’s a challenge to see beyond the horrendous tragedy in Ukraine and the significant macro-economic headwinds for investors. Fundamentals appear to be deteriorating with high inflation and softening growth. This has brought increased market volatility. That means total returns across most asset classes become unanchored from underlying cash-flows. Market beta is challenged by the worsening fundamental picture so positive returns need to come from alpha – active management of risk through trading and hedging. That requires both skill and luck.
Investors face a set of themes that have a significant influence on expected market returns. The war is playing out already through higher energy prices and downgrades to growth forecasts, especially in Europe. The broader inflation theme is clear, and we were reminded of this with the release of consumer price inflation data for March in the US (8.4% y/y) and the UK (7.0% y/y) and producer price inflation in the States (11.2% y/y). Investors hope we are close to the peak in terms of these annual rates but there is more to the inflation story than just the profile of the headline rate (more later). There are related market themes that also challenge investment strategies – rising short-rates, a strong dollar, and high earnings from commodities that are challenging ESG focused strategies. The outlook for China is uncertain as it continues to plough a different path in terms of economic policy and its management of COVID. Finally, there are the long-term themes around economic and environmental security. It was so much easier when growth was steady, inflation was low and central banks were supplying cheap money. Those days are gone.
Inflation is bad for bonds
Inflation punishes holders of fixed rate nominal bonds. The real value of the principal is eroded by inflation over time and the real value of the coupon payments diminish with inflation. Buy-and-hold fixed income investors have to trade off this poor real return profile against capital security and the value of bonds in hedging long-term liabilities (unless they are linked to inflation). For marked-to-market bond investors there is the additional hit from higher interest rates as monetary policy tightens.
Credit offers some limited protection to the extent that coupons (yield) are higher. Minimising inflation erosion of the real income on bonds and the sensitivity of marked to market capital values to interest rates suggests low duration, high-yielding bonds. I have long been an advocate of short-duration high-yield strategies and remain so, even with the growth (and therefore credit) outlook challenged. Floating rate securities also reduce interest rate sensitivity while generating higher yields because of their underlying cash-flows in assets like asset-backed and leveraged loans. Yet it must be kept in mind that a debt obligation that issues and redeems at par will see the principal eroded by inflation and at 8% this is much more of an issue than at 2%.
Link to inflation
Inflation linked bonds are the best fixed income assets in an inflation. The principal is indexed to inflation and the income is based on the coupon rate applied to the indexed principal value. Again, minimising the duration is advisable, especially for active strategies that want to avoid the negative impact of higher interest rates. Even if inflation has peaked, the indexation is going to remain attractive for some time. And the indexation is the same for short and long dated inflation-linked bonds, so best to avoid the negative of rising rates by staying at the short end for now.
Bad inflation, bad for margins
For equities, the headwinds are potentially slower growth (revenues), inflation (margins) and interest rates (debt). Because the driver of inflation has been higher commodity prices, producer price inflation PPI) is running much higher than consumer price inflation (CPI). This points to pressure on margins if we think about PPI influencing costs and CPI being more reflective of revenues. There have been a few periods where PPI has been significantly above CPI for a meaningful period of time. In the 1970s it happened because of the oil price shock. In the 2000s it happened because of the commodity super-cycle being driven by China’s strong growth post-WTO entry in 2001. Both occasions saw significant increases in interest rates and a sharp decline in corporate profitability.
Not all equities are the same. Ideally companies should have stable revenue growth which means a dominant market position, an ability to withstand or manage cost inflation, and low debt. Quality growth as my equity colleagues like to call it. The problem is, on the whole the valuations for these types of stocks are still rich. They have come down, but the risk is that there is more downside to ratings, especially as things worsen on the growth and interest rate front. Higher yields mean a higher discount rate lowering valuations. Combine that with downside risks to profits and it is easy to be concerned about equity market beta too.
Inflation risks remain even after peak
In all inflation periods bond yields (term premiums) rise and price-earnings ratios (equity risk premium) fall. There is limited confidence in saying that this process is complete in the current cycle even if the peak headline inflation rate has been reached. Energy prices remain subject to what happens geo-politically. Food prices are rising because of supply disruptions. Labour markets are tight and are seeing wages grow. Companies are passing on higher costs to their customers. Inflation will stay high for the foreseeable future.
What we learned in the global financial crisis was that the global monetary system was complex. The granting of a 120% loan-to-value mortgage in the north-east of England was linked to money market funds breaking the buck in New York. Today, the lesson learned from the COVID pandemic is that supply chains are extremely complex. A factory worker in Vietnam unable to work because of illness is linked to the unavailability of timber on a construction site in Chicago. Central banks and fiscal support for balance sheets were able to provide relief to the financial crisis. It’s more difficult to see a policy solution to the blockages in real-economy supply chain complexities.
All the fundamental forces in play at the moment are negative for market beta. That means trying to offset that with aggressive alpha strategies, or adjusting portfolios to a more defensive stance. In fixed income, the ideal stance would be to have limited exposure to duration and protection against inflation through an optimal credit and inflation linked exposure. Given there is more volatility, higher yields and wider spread, an alpha strategy should be well diversified and driven by trying to capture changing market sentiment towards interest rate moves and credit quality. On the equity side, quality growth should eventually outperform but there may still be some valuation adjustments to go through. The US is more expensive but better from a fundamental point of view. In the very short-term, and this is more difficult to square with an ESG approach, companies that earn an economic rent from higher energy and materials costs will do well. Indeed, they have with commodity businesses being at the top of the equity return table so far this year.
Much of the above will shape the investment outlook for a while.
There are short-term trends also. The release of the US inflation data showing signs of moderation in core inflation has allowed the Treasury market to rally in recent days. The 10-year yield has moved down to below 2.70% from a recent peak of 2.85%. The peak in forward bond yields has also come down. For now the view is that enough Fed tightening is priced in and that provides some stability on the rates front. Total returns can thus be better in Q2 than in Q1. It’s about short-term alpha, trading the range and being ready to put the tin-hat back on if things take a turn for the worse. For equities, the near-term is all about earnings and the expectation is that Q1 EPS reports won’t be too bad. So some Spring hope.