For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
We aren’t great believers in forecasting the future, but it is customary at this time of year to offer a year in review and outlook for the next. Rather than forecast expected returns for the future, our process allows for a range of plausible scenarios around which we construct robust portfolios to offer good returns for an acceptable degree of downside risk. We don’t aim to make a point estimate of what might happen next year, rather think in terms of most likely outcomes and the positive and negative possibilities. These of course, will be a function of where we are now in the economic and market cycles and what is currently in market expectations.
The soft landing camp?
Markets have all year been anticipating an economic slowdown or even contraction in the US (Europe is arguably already in decline), because of the rapid rate of interest rate rises. This has failed to materialise and as a result commentators have either pushed out the recession to next year or even switched to the soft-landing camp. Few are in the reacceleration camp. Soft landings are the dreamed of, but rarely seen scenario, in which the economy slows to a more normal rate, but never contracts. This can solve the problems of high inflation without the need for the pain of a recession.
Throughout this, long term rates have been relentlessly rising while the stock market has been dominated by the ‘Magnificent 7’ large cap ‘growth’ stocks. Credit markets have remained very calm outside of the property sector. Broadly, this could be seen as a risk-on environment, particularly when you consider defensives such as consumer staples and utilities doing relatively poorly. When you look into the detail, where performance of small and mid-caps has been dire, with valuations getting ever cheaper, things become more nuanced. Perhaps small and mid has discounted a recession, whereas large cap has been buoyed by liquidity.
Old normal is the new normal?
We think this behaviour is consistent with our higher for longer hypothesis. We think rates are now somewhere in their new long term range and inflation is more likely to reaccelerate, than settle at the market’s expectation of something akin to the old normal.
Unfortunately, we didn’t have sufficient exposure to the tech monopolies to perform especially well this year, partly because of our portfolio construction discipline (we really don’t think it appropriate to expose clients to such concentrated risk). The performance of big tech can be justified, however, as monopolies are well set to benefit from higher inflation, their customers have little choice but to use their services at their price.
Looking forward, it pays to consider what might happen to various asset classes in a range of credible scenarios. We think the main drivers of future outcomes will be interest rates, inflation, fiscal policy and growth overall. In that framework, we can classify asset classes into categories on their likely performance because of anticipated changes in those variables. Government bonds might do well in a weak economy with falling rates, but poorly if government spending is higher and inflation rising.
The goldilocks scenario
Starting with the fabled soft landing and reacceleration scenario. This might imply a less favourable environment for government bonds, with the expected rate cuts failing to materialise, but an ongoing attractive equity environment. Pure inflation proxies such as property and commodities might be dull in this environment. Broadly this is the goldilocks scenario where bonds will earn their yields, with maybe small capital loss depending on duration, but equities may march ever higher.
In the reacceleration and inflation scenario, equities and other real assets may perform strongly, while bond yields will push higher. The key here will be the degree to which the yields on bonds are able to offset capital losses, hence shorter duration will earn positive returns but further along the yield curve will struggle.
And what if recession decends?
In a more negative scenario of deflation and recession we would expect equities to be weak, although much of the market has been trying to price for this scenario for some time; it was until recently the consensus. Bonds may perform very strongly, from current yields, potentially giving double digit total returns.
In the round it seems to us that, even at the extreme, the current starting levels offer the opportunity for positive returns and even high positive returns across a wide range of plausible outcomes; particularly if portfolios are well constructed to allow for the uncertainties.
We think having a strongly income generative bond portfolio with small but limited duration risk whilst not maximising returns in bearish scenarios may generate attractive returns across all scenarios and enough capital gain to offset equity losses in the weak scenarios in our more defensive funds. Even our more aggressive portfolios may be well positioned given the starting levels of income coming from both our equities and bonds.
No pain, no gain
Which brings us onto an important closing point. We have moved from a long-term deflationary regime to a more normal regime of mid-single digit rates and inflation. This transition has been painful for many, with large losses in many bond portfolios and mediocre returns from equity markets.
The starting point of any investment journey is important and with bond yields much more attractive and equities having peaked two years or more ago, in many cases, I believe that the current starting point is very attractive.
Investors with a medium-term timeframe may be handsomely rewarded in the coming years. To believe otherwise you must believe that we are in the starting phases of a long and deep equity bear market which, outside of a few notable exceptions, I find hard to accept given valuations in the most part are remarkably low. You’ve taken the pain, now sit back and collect the gains.
