Dear Readers,
Before we continue in our asset allocation series, here’s a quick update on how the markets have shaped up over the last few months:
As far as developed markets are concerned, we have been bullish on equity in general compared to debt markets, as you would have read in some of the published research on the USA and Japanese markets. Here’s a snapshot of the YTD performance for the US, Japan, and the World index overall:
Source: MSCI, Investing.com
With regards to the debt markets, we have been overweight on emerging market debt over developed markets for longer duration bets. In the developed market debt - particularly the US market, preferred to keep the portfolio duration profile on the shorter end given the rising interest rate regime and sustained negative term premia. Inflation-linked bonds were another promising avenue that we discussed in the previous article on USA Asset Allocation, especially on the back of the poor performance in 2022. Given that some of the emerging markets were well ahead in the rate hiking cycle and overall inflation has remained sticky globally, this thesis has played out well in the last few months.
Source: iShares, SPGlobal (YTD returns as at 22 September 2023)
Overall, the numbers suggest that the thesis and ideas have played out well, thus far. As mentioned in our H2 Outlook Presentation, I have made some changes in the portfolio and have gradually trimmed down some equity positions, notably in the US Tech where valuations looked a little stretched.
Understanding the behavioral aspect is key in our investment framework. The narrative in US has quickly shifted from high inflation to getting closer to the 2% target, over the last 6-7 months, acting as a tailwind for equities even though fundamentals have largely remained in check. Thus, as inflation numbers come down from a high base of last year, I expected equities to rally which has been the case thus far in 2023. However, valuations have started to look a bit stretched now in certain pockets like the US Tech, and some small and mid-caps in the Indian market which I track more closely. I have started trimming down some exposure in these areas gradually. It is also important to recognize the fact that markets and valuations can remain irrational for a long time and taking off money completely from equity is not the best idea. Having a clear entry-exit criterion is key in an investment framework. A good time to look for exit is when valuations are stretched, not all at once, but gradually till either valuations are simply exorbitant or there are significantly better investment opportunities from a risk-reward perspective. Overall for the equity portfolio, maintain a positive stance from a medium-term perspective but in the short term, I’m keeping a close watch and trailing stop loss to unwind some positions in pockets where momentum has been strong and continue to rebalance the portfolio with a more value tilt- adding Japan, select Indian companies, some UK exposure and in short-term debt and gold in the defensive section of the portfolio.
As far as the broader debt market is concerned, most of the developed markets are now beginning to pause on further hikes which will ease some pressure off debt markets. However, still keeping the duration profile on the lower side with term premia being still marginally negative in the USA (albeit its come off well in the last few months). I expect this to normalize fully in the medium term (marginal steepening trade). Overall, no longer bearish on long duration given term premia is now inching towards normalization.
The Fed has been doing “Quantitative Tightening” since mid-last year if we just look at the reducing balance sheet. However, if you look at the net liquidity (adjusted for TGA and Reverse Repo), we have hardly moved a needle here. It’s been flat. Another indication of why equities have done well despite the rising interest rate scenario. The Fed has to consistently increase liquidity to ensure debt refinancing is possible (given the huge debt-to-GDP ratios). They have to do this stealthily to ensure markets remain calm as much as possible and avoid a situation of exacerbating inflation in the medium term.
Source: Refinitiv, Pictet Asset Management
The Treasury laid out the $1.85 trillion debt issuance program in H2 2023 earlier in July. While this would have led to much higher yields and sharp equity correction – we have not seen it yet. A key reason behind it has been the fact that the Federal government can simply drain up the RRP reserves. The RRP is down from $2.3 trillion to ~$1.4 trillion now. Not sure, how long this last, but given the run rate won’t be surprised if this is drained out by mid-next year.
Much of this treasury issuance is being financed by draining out RRP. The RRP is where many institutions park their cash and earn risk-free returns (as it is backed by the Fed). This RRP buffer funding has helped them keep bond yields in check (indirect way of YCC perhaps) which otherwise would be significantly higher and we would have seen it trickle through in a stock market correction as well.
By next year, we will see the US debt close to $35 trillion with much of it being short-term debt issued post-pandemic that needs to be rolled over again! Rolling over this amount of debt will keep rates higher for much longer. The increasing interest burden only leads to the issuance of more debt- a vicious cycle indeed. Once the reverse repo is drained completely (which looks likely), yields could jump significantly higher across the yield curve, which makes me stay put on taking a high-duration bet on bonds. Here are some statistics on the US treasury net issuance over the past 4 months:
Bills (<1yr duration): +$1.1 Trillion $0.9T of the 1.1T in Bills was funded by withdrawals from RRP (roughly 80% of issuance)
Notes (2-10yrs duration): -$0.1 Trillion
Bonds (20yr+ duration): +$0.1 Trillion
Putting it all together, we are in a fine decade where active asset management is the way to go. We’ve increased positions in the defensive portfolio – largely short-term debt and gold while selectively trimming down exposures in the high momentum segment in the equity portfolio. From a behavioral standpoint, markets are not overly optimistic but there is an increasing sense of optimism while investors are keeping some powder dry (in cash) to jump on any corrections. So, don’t expect any significant downside if any in the immediate term but the risks are certainly on the downside if any major credit event takes place. Given the fiscal positions the central governments find themselves in, there is certainly a strong case for it.
Over the medium term, I continue with my thesis of a more volatile investment environment on average as compared to what we have seen over the last decade. Maintain the stance that inflation and interest rates are likely to remain higher for longer. A clear indication in that direction is the fact that we are starting to see revised guidance for rate cuts now being expected in 2024-25 instead of 2023.
UK – A potential contrarian market opportunity?
UK looks like an interesting bet in the current situation with the UK equity market not performing well over the last two decades (~1% CAGR if you take it since the start of the 21st century and flat even on the last 5-year basis for the headline FTSE 100 Index). What this has led to is an under-owned position in global portfolios with market sentiments and valuations at significant lows relative to other developed markets and also relative to its history. It seems a rather consensus opinion that the UK will have a sluggish growth outlook given the sticky core inflation numbers, high wage growth, and a rising interest rate regime. While I agree that growth will likely be sluggish, my thesis for taking a contrarian bet is the same as we saw in the USA – declining inflation on the back of a high base leading to a turn in market sentiments. Inflation was at its peak in the second half of 2022 in the UK, so expect some easing on that part. Wage inflation should also normalize over 2024-25 and could potentially change the gloomy investment outlook for the UK -especially in the small and midcap companies which have been out of favor for quite some time now.
The equity valuations in the UK already reflect much of the macro problems in my opinion (see chart below). The correction in valuation also coincides with Brexit in 2016. Expecting to see some consolidation in the near term but don’t see a major correction from here on and it might offer a good risk-reward setup, especially in the Small and Midcap space. We expect inflation numbers to cool off in the coming months which should act as a tailwind for the equity market.
Source: Factset, Lazard Asset Management (As of 30 June 2023)
As far as the debt markets are concerned in the UK, the story seems similar – an inverted yield curve for quite a while. If the yield curve were to normalize (steepener trade), I feel it is prudent to keep the duration profile low. Market sentiment seems to be that we are close to terminal rates in the UK given the weakening economic outlook and expectations that inflation and wage growth will cool off. It could perhaps be a good option to pick up some positions in UK debt as well but maintaining a neutral stance for the time being.
As for the property market, staying away from it for the time being given the fact that a good portion of mortgages will be up for renewal in the coming years (see chart below) and will see their EMIs go up significantly. This will add pressure on incomes and increase mortgage delinquencies.
Source: The Guardian
Another factor is the affordability. Housing prices have been in a long-term bull run in the UK and have outpaced wage growth substantially over the last few decades. The average house price to average earnings ratio stands at ~9x today – which has been in the 4-6 range over many decades. The below chart while slightly dated, is true even as we speak. This will take a long time to correct itself.
Source: Schroders
That was a quick summary of the UK investment outlook and a wrap on this month’s asset allocation series coverage. Please do let me know your thoughts and I wish everyone a great week ahead!
Until next time,
Shivam Jain
Disclaimers:
The information provided in this content is for educational purposes only and should not be considered as financial or investment advice. I am not a registered investment advisor and do not provide personalized investment recommendations or guidance.
Please consult with a qualified financial professional before making any investment decisions.
The views and opinions expressed in this content are my own and do not necessarily reflect the views of my employer. The content is intended to share educational insights and general information related to investments and macroeconomic trends. It should not be interpreted as official statements or representations from my employer.
Any references to specific investment products, services, companies, or strategies in this content are for illustrative purposes only and should not be considered as endorsements or recommendations. You should conduct your own research and due diligence before considering any investment opportunities.
Comentários