What do markets have in store?

For investment markets, 2022 has so far been one of the more interesting and fascinating years since the early 1990s. This year, markets have been on a trajectory that is in direct contrast to the path they followed in H2 2021, where returns were supported by low interest rates, low inflation, ongoing fiscal stimulus, growth as a result of the impact of the vaccine rollout, and the ongoing re-opening of the global economy after COVID lockdowns. This year investors have had to navigate significant market volatility, grappling with the highest levels of inflation seen for three to four decades and interest rates that have risen in the US and Australia at a record pace. In this article, we reflect on where we currently are in markets and offer some insight into what we can possibly expect as we look to 2023 and beyond.

The era of ‘easy money’ appears to be over

The investment environment we have seen over the past 20 to 30 years is one that has been characterised by lower interest rates, abundant amounts of liquidity (or ‘easy money’), and low inflation. During this period of ‘easy money’, central banks and governments globally struggled since the early 1990s to increase inflation to anywhere near its target or target bands. Contributing factors to this phenomenon of low inflation included lower birth rates, globalisation, and technological change (brought about by improvements in computing, telecommunications and networking).

As inflation has increased and central banks have begun raising interest rates, the impact has been felt across all asset classes, including bond markets, which are usually regarded as ‘safe havens’ but where returns have fallen by as much as -10.5% globally and -11.5% in Australia over the past year (as measured by the Bloomberg Global Aggregate index (Hedged) in Australian dollars and the Bloomberg Ausbond Composite index to 31 August 2022).

Inflation and interest rates will continue to be a key focal point for markets

Looking forward, the major concerns for markets will continue to be inflation, corresponding interest rate moves, and whether this means the economy will experience a hard or soft landing (or something in between). 

Markets are also watching closely to see what happens in Europe and the impacts of a lower gas supply from Russia, as well as the role that China will play with respect to any rebound in growth.

For Europe, it will need to revisit where it gets its energy from and what this means from both a short- and longer-term perspective. Prior to the Russia/Ukraine war, Russia was the largest supplier of natural gas to Europe, responsible for around 40% of Europe’s supply, according to the International Monetary Fund. With Russia now partially shutting down its supply to Europe, this will create supply and pricing impacts across all energy markets, particularly as Europe moves into the northern hemisphere winter and energy demand increases. From a pricing perspective, heavy industries such as smelters, glass and ceramic factories, and ammonia plants will become uneconomic and will likely shut down as electricity prices soar. This will then impact medium and light industry, and then services, as well as households.

Have we reached ‘peak hawkishness’?

With markets focused on the path of interest rates, one of the key questions on many investors’ minds is whether central banks have reached peak levels of hawkishness. Historically, when we have experienced inflation at the levels it is currently at, it has generally led to a recession. This has either been the result of rising prices lowering demand, or central banks increasing interest rates and this subsequently lowering demand.

As we discussed in Four strategies for steering through H2 2022, we believe there are two possible scenarios for inflation:

• Scenario 1 - Inflation has peaked or is close to peaking. In this scenario, central banks will continue to increase rates to dampen demand, but will do so in a less aggressive manner. This will lead to a ‘soft-ish’ landing, but one where growth still slows materially over the coming year.
• Scenario 2 - Inflation continues to rise. In this scenario, central banks will increase rates aggressively in an attempt to ‘crush’ inflation at any cost. There is a risk that this approach could tip economies into a recession. There is also a risk, even if inflation recedes, of policy error driving the same result.

Consensus is that interest rate hikes will continue to decelerate relative to the velocity of increases we have experienced in 2022 so far. The peak interest rate is expected to be 3.5% in the US and 2.75-3.00% in Australia. In Australia, the market has priced in rate cuts in H2 2023 or early 2024 depending on if, when and where inflation ‘settles’. If, as expected, inflation ends up between 2.5 and 4.0% and there is no hard landing, this would allow central banks the flexibility to trim rates in 2023/2024, in line with market expectations. The other scenario is that inflation continues to rise, necessitating further rate hikes (most likely before end-2023) and a desire to take inflation below 3% - and quickly!

Our view is that inflation will fall by year-end in the US and be lower in the first half of next year in the UK, Europe and Australia. We are already seeing deflation in goods occurring, but now need to see some ‘demand destruction’, particularly in services, to drive weaker services inflation ahead.

With inflation currently around 6% in Australia and 8% in the US, we note that a fall to 5-6% should be comparatively easy (as prior supply-chain, commodity price and other pandemic-related pressures ease). More challenging will be a move below 5%, given the backdrop of very low levels of unemployment, increasing wage inflation, structurally higher energy costs, and a move from ‘just-in-time’ to ‘just-in-case’ inventory management (in other words, moves towards further near-shoring or deglobalisation).

So, what does this mean for markets? In this environment, it is difficult to have very high convictions with respect to any asset class, and we are currently close to neutral in our tactical asset allocations.

Our current view on equities

As outlined in August in Recent rally leaves global equities more vulnerable, we feel the path from here is uncertain for equities. We remain cautious and recommend that any overweight positions relative to strategic asset allocations are trimmed, and where there is capital to be deployed, that this is invested in a ‘patient’ manner.

What’s driving our view?

Although central banks (including the US Federal Reserve and Reserve Bank of Australia) are raising rates now, markets are factoring in rate cuts from mid-2023. However, we believe that the hurdle for a central bank ‘pivot’ (or a move to cut interest rates) is higher than markets currently expect. There is a reasonable likelihood rates will peak late in 2022 and remain around these levels until at least late 2023.

With the recent fall in equity markets, valuations have recalibrated towards longer-term multiples and in line with pre-COVID levels. From here, we feel that it will be difficult for multiples to expand from current levels, given the uncertain economic outlook and the higher cost of capital. Although the most recent reporting season suggests that, for the most part, corporates are holding up relatively well, we question whether current earnings estimates are accurate.

What would change our view?

For equities to rally meaningfully, we believe that a ‘Fed Pivot’ would need to occur sooner rather than later (and a lower inflation outlook would be key to this), multiples would need to expand beyond pre-COVID levels, earnings would need to be stable, and profitability would also need to expand beyond current levels, which is already at record highs. In the current environment, we believe this is unlikely. In the event there is a recession, this would provide a better buying opportunity as valuations and prices are rebased lower. In a soft landing scenario, valuations will also move to more reasonable levels, but we are unlikely to see much lower equity prices.

From a relative value perspective, we favour Australia over offshore equity markets. Overall, we believe the domestic economy remains in relatively good health supported by low unemployment levels, reasonable valuations relative to longer pre-COVID averages, and a less severe path of inflationary pressures. Additionally, Australia has robust terms of trades, driven by hard commodities and energy, which we expect to at least continue in the short to medium term. We view the US dollar as currently stretched, and expect the Australian dollar to rebound, favouring our domestic equity positioning.

Our current view on fixed income

As outlined in Bonds reclaim their yield…It’s time to lift allocations, we currently prefer government bonds, and within credit, we prefer higher-quality investment grade companies.

What’s driving our view?

In a soft-landing scenario, government bonds will likely perform well (and even more strongly if a recession were to emerge globally), with 10-year bond yields in Australia and the US currently trading around 4.0%. In contrast, spreads for sub-investment grade/high yield credit are not quite wide enough at 6.00% over government bonds. This suggests they are not a value proposition just yet.

Currently, credit fundamentals across corporates are solid, where businesses generally have higher cash balances, lower leverage than historic levels, and debt that has been termed out at lower rates. However, for lower quality companies (or for those that are now often referred to as ‘zombie’ companies), the ability to maintain margins in the face of rising inflation (and the ability to meet higher interest costs) will become increasingly difficult. Additionally, some companies will find it challenging just to refinance their existing debt, let alone increase it.

Our current view on private markets

Broadly, we favour high-grade core, along with core-plus within commercial real estate and infrastructure, where returns are driven by asset and operational improvements. For new investment capital within private debt, we prefer domestic high quality private credit. Similarly, within private equity, the opportunity set is broad for new capital to be invested at potentially much lower valuations across venture, growth and buyout.

What’s driving our view?

At a broad level, private markets have been a significant beneficiary of the low inflation, low interest rate environment we have experienced over the past few decades. When (interest) discount rates fall, asset prices rise (and vice versa), and falling interest and discount rates over the past few decades have been broadly positive for multiples in both public and private markets. In an environment of rising interest and discount rates and higher inflation, this is likely to be a headwind, with inflationary cost pressures squeezing margins.

The pressure is, therefore, on investment managers and general partners to start ‘squeezing the lemon’, so to speak, at the asset or portfolio company level to improve operational performance. There will no longer be a free ride from financial engineering (multiple expansion), which means that to increase value, there will need to be margin expansion and revenue growth through real operational value add capabilities. Lingering issues, such as labour shortages and supply chain issues are also likely to remain challenging, exacerbated by the COVID pandemic and Russia-Ukraine war and their impact on ‘near shoring’. On the labour side, productivity and automation will continue to help over the longer term - but in the shorter term, labour shortages will put upward pressure on wages.

Below, we discuss the outlook for private equity and private debt, property and infrastructure, and hedge funds.

Private equity and private debt

According to Mario Giannini, Chief Executive Officer of Hamilton Lane, quality companies should be able to perform in a moderate environment where inflation and interest rates are both between 2% and 5%. In general, in this environment they should be able to grow revenues and maintain or grow margins.

Those companies with pricing power should be able to offset some inflationary pressures by passing on higher input costs. Companies with strong balance sheets, that can contain costs, have decent cashflows, and maintain or grow revenues should also have the flexibility to find new ways to create value. As an example, they may be able to expand vertical integration, take over competitors, or introduce new product lines.

For closed-end and evergreen (open-end) private equity funds that have recently raised capital to invest, the timing is arguably very good, as tempering valuations in both public and private markets should provide a wide range of opportunities across all areas of private equity (growth, buyout and venture capital). Whether or not you invest more capital depends on your risk appetite, the opportunities available, and the relative weight of private equity in your portfolio (or your strategic asset allocation).

With respect to private debt, as with fixed income investments, this can provide reasonable levels of income, and as many private credit strategies are also floating rate in nature, they can also provide a level of protection against inflation. As lower quality credit companies begin to deal with higher interest rates and debt servicing requirements, there may be an opportunity to invest into private debt at lower levels, particularly in quality companies or assets that have short-term financing difficulties.

Property and infrastructure

Both property and infrastructure provide a level of income which remains resilient in periods of volatility and inflation, particularly for those assets that are providing essential services. They also provide a level of inflation protection, as they are able to increase rents and/or revenues, typically in line with inflation.

Rising interest rates obviously have an impact on capitalisation rates for real estate and discount rates for infrastructure. Whilst this is negative from a valuation perspective, property rents should keep pace, if not exceed, inflation. This is also the case for infrastructure, where assets with pricing power (e.g. toll roads) can pass on inflation via higher prices.

Going forward, there are greater risks associated with assets that don’t have any pricing power, are lower quality, and/or have higher levels of debt and interest payments. We, therefore, favour core real estate and infrastructure, which focuses on higher quality assets, along with core-plus strategies, which aim to generate excess returns through asset improvement (rather than financial engineering, as was discussed earlier in the section on private equity).

Hedge funds

An increase in market volatility and, by extension, dispersion (i.e. a wider range of investment return outcomes) is typically a good environment for hedge fund strategies, such as global macro, trend following, market neutral/lower beta, relative value, and event-driven strategies. These strategies do not necessarily need markets to go up or down, but generate return by using skill to exploit shorter-term opportunities as a result of market dislocations. As such, they provide another source of less correlated returns to diversified portfolios.

In summary, what does this mean for investors?

Irrespective of whether we experience a hard or soft landing, the era of ‘easy’ money and low inflation appears to be over, and it is reasonable to expect lower investment returns and greater volatility in markets going forward. 

In this environment, it is difficult to have very high convictions with respect to any asset class, and we, therefore, remain close to neutral in our tactical asset allocations (with a preference for tactical positioning within asset classes, as discussed).

The key to managing portfolios is to maintain a disciplined investment process and to ensure portfolios are regularly rebalanced back to strategic asset allocations. Beyond this, the key to adding alpha is to focus on: active management and applying tactical asset allocation tilts where appropriate; quality investments and avoiding significant style tilts; and finding opportunities in alternative investments.