Interest Rates & Quantitative Tightening
As the realisation sinks in that inflation won't be transitory after all, investors have been struck by quantitative tightening, multiple expected consecutive rate rises in 2022, and now an inverted yield curve.
What does this all mean for asset allocation, and how should investors adapt their portfolios?
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Whether the 2022 bear market is ending may seem a fruitless question. Most market forecasters got 2022 wrong. Even today, 2023 consensus earnings estimates vary widely from high single digits to negative 15%. Added to that are the market historians who point to various pervious market downturns over the last century to support their views. Which collectively suggest that the likelihood of 2023 being a down year is low. But what is the reality. Will stocks bounce back in 2023?
The answer is not so simple. It hangs on a multitude of conditional expectations which make prediction difficult and path depemdent. In particular, the path for inflation and rates. Both of which will impact growth and realisable corporate profitability.
Adding to the complexity are the causes and solutions to the current inflation mix, with both commodity inflation and wage inflation being the most tenacious to tame. If monetary policy fails to bring inflation down without a disproportionate decrease in growth, even the current depressed multiples may prevent a stock bounce back in 2023.
In the meantime, the smart money seems to have a preference to ride out 1Q23 with a portfolio tilted towards the quality, dividends and credit.
It's that time of the year that global financial market outlooks fill our research feeds. They are popular throughout the entire business cycle. But this time around clicks have gone through the roof.
We only can conclude that investors are feeling pain in their portfolios. And are looking for the right medicine to soothe their dry throats. And as the bear market firmly takes hold, the 60-40 portfolio has stopped working, and the economy heads towards recession, they are clearly looking for new ideas.
Given the amount of clicks for long term risk premia estimates across all asset classes, we can only assume that Chief Investment Officers and Strategists are refreshing their portfolio assumptions. There's a lot happening on the macroeconomic front as inflation and rates rise, and global growth is continuously revised downwards. This type of research trend on RFPnetworks has historically preceded significant portfolio rebalancing by our clients.
60-40 portfolios may struggle.
What has led to the breakdown in stock-bond correlations in 2022? Inflation? A changed macroeconomic environment? Will the 60-40 portfolio ever work again? Or should it be recalibrated back to reflect the covariances of a different decade.
Questions such as these are at the forefront of portfolio design today. The classic long equity volatility and bond duration portfolio is not working, and is causing a conundrum for asset allocators.
Depending on which economist, strategist, equity or fixed income portfolio manager you follow, the view that we are now in stagflation varies. But that difference in opinion is not the interesting thing. What is more interesting is the variation in the underlying models and analysis they point to, in order to draw their conclusions. The lack of consensus is notable.
What is obscured is causality.
Professional Investors have recently been rotating their portfolios based on the view that inflation is not going away soon. But is this a given?
Looking at headline CPI alone does not tell the whole picture. Digging into the US core CPI excluding food and energy costs, the 'other' drivers of inflation recorded a mediocre 0.3% increase in March in the US - the slowest pace in 6 months.
The world has had time to re-group and re-plan. And as such, the 'other' factors driving inflation - tight labour markets, supply-chain disruption and pent-up demand for a return to normal living - are resulting in a re-normalisation that supports the 'transient is back' argument.
Professional investors are being forced to reconsider their investment portfolio design. The efficacy of passive investing going forward is being questioned. And active asset managers are raising their voices, pointing to the abundant supply of alpha across asset classes where region, country, sector and company return dispersion has widened. Curiously, the professional investor community is listening.