Through the Looking Glass

Markets continue to oscillate as economic data neither confirms nor denies the bull or bear case. Two key US economic prints diverged in the first quarter, with US Gross Domestic Product (GDP) coming in stronger than expected, highlighting how robust the economy remains, but Gross National Income (GNI) contracted for a second quarter and remains recessionary. These kinds of conflicting signals are typical at the end of a cycle, as a hot economy starts to sputter out, but it’s not obvious if or how fast it may fall. We still believe we are heading for a recession – our recession models continue to flash red with over 65% of the indicators confirming (still the highest level since 1990). Typically in a new bull run, market breadth is extremely strong three months after the bottom. Almost nine months in and market breadth remains abysmal, with only a handful of stocks leading the markets higher. We are not seeing the economic or market data consistent with a new sustained bull market, so remain dubious of this recent rally in stocks linked to Artificial Intelligence.

However, rather than re-hashing our cautious thesis which hasn’t really changed, or getting bogged down in different scenarios if the US fails to lift the debt ceiling (which at the time of writing appears to be a done deal), we thought we’d take the opportunity to extend our horizon and work through the longer-term implications on the global economy and markets over the coming years.

A return to structurally higher inflation?

There is growing evidence that inflation is moderating, but some of the secular drivers of disinflation are reversing. We believe the key drivers of disinflation over the past 35 years can be grouped into five key themes – demographics, productivity, manufacturing, the wealth divide, and energy & geopolitical security. While the evidence is patchy, we have given the benefit of the doubt that aging demographics will help keep a lid on inflation and that advancements in software, robotics and artificial intelligence will help boost productivity. However, the other secular trends are deteriorating.

Goods disinflation benefited from globalisation, but COVID-19 highlighted the need for supply security and the need for ‘just-in-case’ inventories. Fracturing geopolitical stability has also required companies to consider onshoring or ‘friend-shoring’ to avoid reliance on single country risk or potential tit-for-tat trade wars, or worse. This is also true for energy security. A lack of investment over the past decade in energy supply puts the developed world in a more fragile place where it is beholden to potential ‘unfriendly actors’ who are not afraid to weaponise the price of energy to their advantage, resulting in greater volatility and higher costs in the long run. This is also true for strategically important goods (such as computer chips) or minerals (such as those required for the climate transition). Finally, the liberal reforms started in the Reagan/Thatcher era saw employee compensation as a percent of gross domestic income collapse relative to corporate profits. US corporate profits as a percentage of GDP is the highest since the series began in 1947 and has risen more on an after tax basis. More recently, quantitative easing further exacerbated income inequality. We have since seen a growing populist movement across the world where workers (a.k.a. voters) have said enough is enough.

We do not believe these issues are going away over the next decade. Governments will have to turn their attention more aggressively to matters of national security, income inequality and the climate transition. This will likely mean structurally higher inflation than the past decade. Loose monetary policy combined with fiscal austerity will likely flip on its head, with central banks fighting to contain inflation with higher rates while governments spend on fiscal imperatives, driving up demand. The build out of national interests requires government expenditure and we believe the voting public will support politicians who advance these causes. This will be an environment where corporate margins will be squeezed, higher cost of capital will increase defaults, but there will be clear winners and losers.

What would structural inflation mean for investors?

This will likely change the investment landscape over the next decade. Chart 1 shows that the rolling 5-year correlation between equities and bonds has only stayed meaningfully negative since 2000, but has been mostly positive or at best neutral over the 100 years prior. The bond equity correlation is most consistently positive during periods of high inflation (1915-1920, the 1940s and the 1970s). Any return to a higher inflation regime would likely lead to more persistent positive equity-bond correlation and more volatile returns from static asset allocation. The efficient frontier shifts in this environment as the return contribution from fixed income increases (thanks to higher yields) at the expense of equities, but the diversification benefit from fixed income is diluted, flattening the efficient frontier. Bonds will still provide useful diversification at times but the correlation is more unstable, requiring more active dynamic asset allocation and the use of cash as a safe haven when bonds are cyclically weak.

Breadth will also likely be important – volatility creates more bifurcation within and between asset classes, allowing investors to search for valuation opportunities or find other assets that may improve the diversification benefit lost from bonds. More structural holdings in inflation assets such as commodities and inflation linked bonds are likely required in this new regime. As the cost of capital rises, default rates in credit are likely to rise and unprofitable equities will be given less latitude, bringing price-to-earnings (P/E) multiples down. At a corporate level, companies with attractive valuations, high quality earnings and the ability to benefit from these thematics (inflation linked earnings, government support, links to onshoring, national security and climate initiatives) should outperform. This should see a shift from passive to active management as fundamentals should drive returns.

Portfolio positioning shifts

While it is likely too early to position for these longer term thematics, investors should take heed of how the landscape may change and start to plan accordingly. We believe our objective based process helps us take advantage in volatile markets, through our dynamic asset allocation process and active security selection, while our breadth allows us to find diversifiers when correlations shift.

For now we are positioning our portfolio for a downturn as recession probabilities increase. Our strategy has been shifting to increasing duration risk and reducing credit risk, particularly higher risk credit, as we believe the riskiest borrowers will struggle to refinance their debt as lending standards tighten. We have been increasing duration exposure to 2.75 years, from 1.75 years at the end of 2022 and we expect to increase further as opportunities present. At 15%, our equity positioning is close to historic lows and skewed to Australia, Japan and emerging markets, which we see as being both the lowest risk and best value.

We continue to hold high levels of cash (which now pays us a decent nominal return as well as being a good short-term store of value). We plan on deploying this cash once (or if) the downturn comes or valuations improve. How governments attempt to stimulate the economy out of the next recession will dictate how the next regime is defined, and this thought experiment will help guide us on how to set up the portfolio for the next cycle.