David Jane
Premier Miton Macro Thematic Multi Asset Team
On trend?
As we come to the closing days of 2022, it is conventional to write a review of the year and an outlook for the coming one, something in most years we avoid. However, the current period has been so exceptional in so many ways that such a review seems worthwhile this year. Towards the end of 2021, we wrote a series of notes outlining our view that equity and bond correlations would turn positive, because of higher inflation. That view has turned out more right than we foresaw, with both bonds and equities suffering this year as central banks tried to put the inflation genie back in the bottle.
Another notable trend this year has been the strength of the dollar versus almost all other currencies. The US has been able to increase interest rates more aggressively than other central banks and this has caused a shortage of dollar liquidity elsewhere.
Finally, there has been the ongoing reversal of many of the previous equity trends which had held for so long. The outperformance of growth strategies, notably technology and ESG focused strategies have seen a dramatic reversal, while previous laggards such as energy and materials have done well. Higher bond yields have favoured value over growth. It is becoming clearer by the day, that many of the previous favourites had become overvalued. What is also becoming more obvious is that the potential to replace fossil fuels, at least in the near term, is highly optimistic. A backlash seems to be beginning to emerge, particularly in the US. The world is one where energy and materials are again scarce.
Are the inflationary balloons deflating?
Near term inflation is coming down, as the big rises in goods prices due to supply chain issues drop out of the calculation of the year-on-year figures. However, wages and employment do remain very strong, so it pays not to be complacent. We are of the view that inflation will abate over the coming year, but not to the degree markets currently discount. Hence, our higher for longer stance, we think inflation will persist higher for most of the decade. This view rests on the global tightness of commodity markets, the ongoing deglobalisation trend and the unlikelihood that western governments reverse course and sort their fiscal stances out.
As a result, our stance in fixed income is to use bonds as primarily an income source and a means of reducing volatility. However, in the near term, as inflation expectations and long-term real growth expectations fall, the potential for a rally in medium dated bonds remains.
The great American playbook
If the US is nearing its interest rate peak of this mini cycle, then potentially the US dollar has peaked this cycle. This has broad ranging implications for the relative performance of equity markets and also for commodities. Emerging markets and commodities are typically stronger when the dollar is weak. However, the current long-term outlook could be beneficial for the US, at least versus other developed economies. The US is an energy and agricultural products exporter as well as having plenty of other natural resources, such as minerals. Its other big advantage is that its workforce is still growing, unlike other big, developed economies.
It doesn’t pay to bet against these factors in the long run, however in the short term the US indices suffer from excessively high weights to certain very large companies which are suffering valuation and profit headwinds. This may hold the indices back, although many other stocks might be doing well.
Moving on to equities
Which leads us into the outlook for equities overall. The market is struggling to price the interlinked factors of inflation, the economic (and hence profits) outlook and interest rates. On the one hand falling inflation should be positive, but if this is because of a recession and falling profits it might be a net negative. So far inflation has been to the benefit of corporate profits, however wage growth is a factor now. In our view inflation tends to come down in waves from the initial spike as the various factors feed through to the price level. We believe corporate profits are at risk as margins are at all-time highs and growth is slowing. Therefore, we think equities are still at risk on aggregate.
However, there are, in any bear market, still opportunities in companies that are attractively valued. This year it has been energy, next year commodity sectors could remain in favour, but we also like industrials in the US, which may benefit from capital investment and reshoring in particular.
Proceeding with caution
Overall, we retain a cautious stance, we think investors remain a little too optimistic on the medium profit and inflation outlook. So, for the long term we retain our investment positions that may benefit from inflation, but we have tempered this with some diversifying exposure in both equities and fixed income and have reduced our US dollar exposure over the past few months materially.
