Four key reasons for adding risk into Q4

It’s probably one of the great understatements to describe markets in the third quarter as “challenging”, with July’s initial bounce in global equities giving way to an ugly 9.3% decline in September. And while it’s a similar story in fixed income, it is noteworthy that Australian fixed income has performed materially better (-1.4% in Sept qtr) than global fixed income (-5.1%).

So the question remains: do we still think the final quarter will bring a more genuine rebound for risk assets? And should we begin to tilt our expectations for a bigger recovery in global markets and in turn, a higher Australian dollar?

In my latest update, I detail my four reasons for adding risk to portfolios into Q4.

Transcript

Welcome everyone, my name is Tim Toohey, Head of Macro Strategy at Yarra Capital Management, and thanks for joining us for our Quarterly Outlook for December 2022.

In our outlook for the September quarter we concluded with the statement:

“The first quarter was tough for financial markets, Q2 was much worse and Q3 remains a challenge. The good news is that Q4 is my line in the sand where I expect equities to begin the more genuine rebound.”

A “challenging” third quarter was probably an understatement, with the initial bounce in global equities in July giving way to declines in August before an ugly 9.3% decline in September. The damage across assets can be seen in Exhibit 1.

For the record, hedged global equites fell 5.2% in 1Q, 5.5% in Q2 and 6.2% in Q3. If you were invested solely in global equities, then CYTD your investment has lost a quarter of its value. A sharply falling A$ helped cushion the blow for unhedged local investors with the decline in global share prices offset by the rise in the value of the US$. Indeed, it’s quite remarkable that in the June and September quarters, local unhedged investors saw the value of their international equity investments largely unchanged.

Thus despite commodity prices being firmly in retreat over the past 2 quarters this A$ weakness and more defensive nature of the Australian market helped the ASX200 eek out a 0.4% return in the September quarter and a 9.6% decline CYTD. Whilst no one likes losing money, our thesis that Australian equities would outperform global equites in 2022 looks to be well in train.

Similarly in fixed income land, Australian fixed income performed materially better than global fixed income, declining 1.4% in the September quarter compared with a 5.1% decline for global bonds. CYTD Australian fixed income has declined 10%, essentially half of the loss in global fixed interest.

So the question remains: do we still think Q4 will bring a more genuine rebound for risk assets, and should we begin to tilt our expectations for a bigger recovery in global markets and in turn, a higher A$? In a word, ‘Yes’.

There are 4 key reasons for adding risk to portfolios into Q4:

1 – Growth expectations have converged to our more cautious economic outlook

We have been well below consensus on our growth views for 12 months and have been actively calling for a US and European recession in late 2022 / early 2023 for most of this year and maintained that China’s growth slowdown would be more pernicious than most expected. Nevertheless, there has been a sharp shift in the consensus views for economic growth in the major economies for both the 2022 and 2023 calendar years, as can be seen via the evolution of the grey and red lines in Exhibit 2.

So despite our long held cautious view on global growth for 2022 and 2023 the reality is that the gap between our forecasts and consensus has narrowed so much in the past quarter that the gap is largely trivial. If anything we are slightly above consensus on economic growth in 2023, but that really is splitting hairs

The point is the reset in consensus growth expectations has now, finally, occurred and from our perspective its now close enough to reality to be less fearful of a further expectations reset.

2 – Financial conditions have tightened so much that a pivot from policy makers is inevitable

Tighter financial conditions have long been the central reason for why we have been calling for a cyclical recession in the US, but the additional tightening in financial conditions over the past month has been so large as to give the Fed and for that matter most other central banks pause.

It might sound perverse to suggest that so much of a bad thing is actually a good thing, but that is exactly where we are as of the start of the Q4. US financial conditions are not just a little restrictive, they are now very restrictive. Indeed, excluding the inadvertently restrictive periods of Covid and GFC shocks they are at their most restrictive since 1990.

The Fed is so attuned to financial conditions it is highly likely that they will signal that small and slower increments of tightening are now appropriate, and even then, they may not follow through.

Over the past month rate markets spent much of the time convincing itself the central banks would just keep hiking well into 2023. From our perspective this was an overreach. A collapse in front end interest rate pricing is now more likely and in Australia’s case it has already commenced, but more of that later.

3 – Real bond rate reset is now likely done.

For much of 2022 part of our caution of equity markets was the idea that real bond yields would likely rise and provide a significant valuation headwind for equities. The idea was once the Fed decided to ‘get ahead of the curve’ and once inflation expectations started to decline real bond yields would start their ascent. Both of these things have now happened, particularly in Q3.

Indeed, the move has been so large that real 10-year bond yields are back around the average level that prevailed in the 5 years prior to the financial crisis and well above any time since the financial crisis. You can see this via the blue line.

The bottom line is this challenge is now largely complete. The Fed are unlikely to get further ahead of expectations and inflation expectations are largely reverted to what we consider an appropriate level, albeit its likely that they will move lower as realised inflation eases.

4 – Earnings expectations are coming back to some semblance of reality.

The number of downgrades across markets has continued to accumulate and the companies impacted are of sufficient size to result in meaningful 1 year forward EPS downgrades.

The S&P500 in October is on track to post a 4.75% decline in forward EPS. Excluding the Covid downgrades, it will mark the largest monthly downgrade since the Global Financial Crisis and 3-month annualised forward EPS growth is contracting at a -17% rate.

Now while that doesn’t sound like a reason to ‘buy’ the market the pace of decline is in line with that suggested by the prior tightening in financial conditions.

There is little doubt that further downgrades are coming but history suggests even with perfect foresight it’s nearly impossible to buy the market on trough earnings and valuations. The objective is to anticipate at what point the economy is likely to show its initial signs of improvement and start adding risk about 8 months in advance of that point.

Given our expectation that the initial signs of recovery should emerge around mid-2023 that puts us right around the current period.

But what could go wrong?

We have discussed on several occasions the difference between a cyclical v structural/balance sheet recession and everything that I have said to date works off the assumption that the looming recession is a ‘run of the mill’ cyclical recession.

The rumours over Credit Suisse were sufficient for financial markets to provide some probability that the world could suddenly leap to a structural recession via something more akin to a Lehman like event. Of course, the more central banks lift rates the greater the probability that something in the financial architecture breaks.

From my perspective if something does break it probably won’t be one of the global systemically important banks (or G-SIBs), not least because under BIS and national government directions a good deal of progress has been made on governance, risk data aggregation and reporting practices such that more accurate, complete and timely reporting of risk exposures and external scrutiny of such reports means that today’s investment banks are very different beasts to what existed in 2007. Nevertheless, they are far from saints. They an inherently pro-cyclical and fertile ground where the greed of a few individuals can overwhelm the best intentions, and capital buffers, of the group. If we had to guess, if there is a shock from this bout of excessive tightening of financial conditions it will be in the now large and unregulated family office space. However, it’s hard to imagine that even a raft of failures in the family office space would pose a systemic risk to the global economy. Rich people being somewhat less rich is hardly the ingredient of global liquidity shock.

Nevertheless, there are three things to bear in mind.

First, stress in the financial architecture is somewhat apparent

The chart on screen shows the global Ted Spread – a measure of short-term funding stress for the banking system. The financial stress foreshocks that predated the Lehman experience have a similar pattern to the 2022 experience, albeit on a much smaller scale. A large liquidity shock is possible but in my mind is still unlikely for the reasons just mentioned.

Second, the impacts of quantitative tightening are still broadly unknown

The chart of screen shows the attempt by central banks to shrink their balance sheets and the direct impact that will have on money supply growth suggests global money supply is set to contract by more than any period in at least 30 years (which is as far back as we can construct comparable data and likely much longer than that).

As an aside, for anyone that started Q3 wading through the papers presented at Jackson Hole the world’s most import central bankers spent much of the weekend declaring that the primary source of excess global inflation was excessive fiscal policy. It was a nice try, but the reality is that the stupidity of central banks to not calibrate their own actions to that fiscal stimuli in real time and then to compound the problem by delivering a 25% growth in global money supply hardly makes them cleanskins in the inflation blame game.

Excess monetary and fiscal stimuli obviously shifts the demand curve to the right. COVID inspired labour shortages and supply chain blockages obviously shifted the supply curve to the left. Any first-year economics student should have predicted that the result is much higher prices, even without the Russia/Ukraine conflict in the background.

The bottom line is central banks need to be very careful in stripping too much liquidity out of the system too quickly. Obviously falling house prices is now a global problem not just an Australian problem and miss-steps on this from could be very costly.

Lastly, the USD could keep rising and break something in the Dollar-linked Emerging Markets

While this is a well flagged and discussed risk and certainly worthy of paying attention to, we think the peak in the US$ is in.

China’s directive to regional banks to start selling US$ holdings to shore up the CNY in concert with financial markets sniffing the wind that the Fed’s bark may not be as bad as its bite suggests very clearly that the US$ may finally have peaked. This has big implications for A$ investors. In a world that still is concerned about China and European risks Australia could be a clear destination for capital.

The implications is the A$ is going up and Aussie bonds may well out perform their peer group.

Of course, things could go right as well. The biggest is that inflation surprises on the downside. That was our central point last quarter, and it remains a central point this quarter. We believe that declining commodity prices, easing supply chain blockages and rising labour supply have been sufficient to stabilize inflation expectations and some easing is now apparent. Excessive profiteering whilst inventory levels were low and demand high has now been met with high inventories and slowing sales, leaving goods prices vulnerable to an extended bout of discounting.

With labour costs likely to remain elevated into slowing sales the main mechanism that will drive lower inflation is margin compression.

So what to do with asset allocation?

The ‘risk-on’ start to Q4 obviously matches to our ‘line in the sand’ comment last quarter. There will doubts by many as to why equity markets can rally with recession risks so prominent and signs of stress in the financial system.

However, growth expectations have been reset, real bond yields have been reset, CBs rate expectations have become excessive and a sustained rally in nominal yields is in prospect should inflation ease as we expect – all of which suggest valuation support.

Of course, the starting point was a bearishly positioned market participants. Given the shift in circumstances, a switch to a ‘hope’ phase for equity markets – where PE expansion drives returns rather than EPS growth – is now feasible.

The speed limit for an equities rally will be the extent of earnings declines in the remainder of 2022, residual geo-political risk and the reality that there is very little by way of additional monetary or fiscal stimulus to kickstart the next economic cycle. Nevertheless, we plan on continuing to lift our risk exposure in coming weeks.

In our Multi-Asset and Income Plus portfolios, we moved to some of largest over-weight bond positions in our history in the September quarter and reduced our cash and corporate bond exposures. A rally in bonds has commenced and this is likely to extend in coming months.

Post the asset price declines in Q3, there are plenty of opportunities across muti-assets in Q4. Equities will likely do best in the near term, and small caps are likely to better than large caps, particularly if the A$ commences its ascent as we expect. A narrowing in corporate bond spreads is also likely as risk premia narrows and attractive running yields are likely to attract capital. EM may well catch a sustained bid, albeit we are happy to stay in the major markets for now.

To be clear, we are not talking a large cyclical recovery in the global economy, we are not talking about near term rate cuts, and we are not talking about earnings surprising expectations. What we are talking about is central banks taking their foot off the throat of financial markets and valuation adjustments supporting a better re-entry point for risk markets.

We hope you have a successful Q4 and look forward to seeing you again in early 2023.

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