Back from the brink

These companies are less likely to receive funding from the capital markets and rely on bank loans to operate, but the senior loan officer survey tightening standards for commercial and industrial loans remains very restrictive, at levels seen during the depths of recession. 

Normally, this would lead to labour shedding, but given how hard it was to find workers post-COVID, we observe that companies are not willing to let go of them so easily, even if it impacts margins in the short term. This has resulted in collapsing labour productivity, with US Nonfarm Business Sector Output Per Hour Of All Persons falling to -1.6% YoY, the lowest since the 1970s.

There are signs of the labour market cracking, however. The number of job openings and average hourly earnings are declining slowly but surely. ISM manufacturing employment is contracting, temporary workers have been shed, and the number of states with initial claims over 20% year on year are at levels consistent with the start of a recession. However, until companies are willing to lay off staff to protect margins, the consumer remains buoyant.

Pushing out the recession call

We originally saw the regional banking crisis of March 2023 as the canary in the coal mine, reminding the market of how damaging aggressive interest rate hikes can be to the economy and the banking sector. We believed a recession was imminent and positioned our portfolio accordingly. 

However, thanks to swift intervention by the Fed, this has been put out of mind for now. Regional banks will have to restrict lending further to pay back emergency loans, but for now this has been liquidity-positive for markets. We are around 18 months into a rate hiking cycle, which is typically when a recession would rear its ugly head, but given how low rates were at the start and how much better household and corporate balance sheets are post-2008, it may take slightly longer this time to play out.

Our recession model is triggered when more than 40% of the signals are confirmed. Our model has dropped from an all-time high of 65% to a still uncomfortably high 50%. However, all of the improvement has come from indicators that lead to a recession by 1-3 months. Those still signalling recession lead to a recession by 6-9 months. 

Combined with the real wage growth extension, we have pushed back our recession call to the end of 2023 or the first quarter of 2024. While this means the economy will likely be hotter than we expected, it also means that the market might be wrongfooted on the soft landing scenario and may quickly pivot to price in a higher for longer rate cycle, which could put pressure on US equity multiples and US duration.

Portfolio positioning shifts

As we take a step back from the brink, we have re-risked the portfolio on the margin. To be clear, we are not bullish, but we are no longer positioning for an imminent recession. Instead, our overall positioning has reverted to similar levels held just before the collapse of Silicon Valley Bank. We have increased our delta-adjusted equity positioning from 15% back to 18%. However, under the surface we have increased equities to 20% but hold a 5% put spread to protect the portfolio from any falls from here down to 4,000 on the S&P. 

This should allow us to participate in any further rally or blow off top, but move us back to 15% equities quickly if the market falters from here. We have also taken off our 5% short high yield credit protection, 4% last month and the remaining 1% this month. Our credit position remains towards its highs but heavily favouring investment grade credit and Australian subordinated and private debt over global high yield corporates. 

We continue to hold elevated levels of duration at around 3 years at the portfolio level, but have been reducing our US duration in favour of Australian duration and moving to shorter dated maturities as central banks near the end of the rate hiking cycle.

We re-risked the portfolio towards the low in September 2022 and believe we captured the ‘safe’ part of the rally, but took chips off the table once valuations were stretched and we entered the more ‘risky’ part of the rally. We continue to hold higher levels of cash as dry powder, earning almost 4.5%, which we look to redeploy into higher-risk assets, if prices correct to compelling valuations or our leading indicators and recession models improve.

Managed Fund

Schroder Real Return Fund - WC

Multi-Asset

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