Asset Allocation Committee Outlook

The economy is starting to feel the lagged effects of tighter monetary policy. It is most visible in the current stresses in the banking system, which are tightening financial conditions still further. We think this has brought us close to the peak in the rate-increase cycle. Together with the cash held aside by institutional investors during 2022, this may explain why equity markets have performed better than we expected so far this year, and why mega-cap growth stocks have led that performance over the most recent weeks. The Asset Allocation Committee (“the AAC” or “the Committee”) does see an opportunity to start planning a journey back to a more neutral stance on risky assets in public markets, but we remain cautious on equities, anticipating volatility as we await the full impact of peak rates. In the meantime, cash and certain pockets of fixed income offer both returns and optionality. Just as important, we favor value and quality as well as regional and size diversity for the new cycle, not the U.S. large-cap growth stocks that led the last cycle and have outperformed recently; the cycle is turning, but we do not believe it is turning as sharply as the market expects, or that we are going back to the era of low inflation and low rates. The message is more urgent in private markets: here, we believe it is already an opportune time to act, as tightening financial conditions and banking-system stresses start to generate opportunities for providers of liquidity and capital who have access to where needs are greatest.

In our last Asset Allocation Outlook, we looked ahead to 2023 through a macroeconomic lens focused on a handful of key points.

Inflation would be surprisingly sticky, forcing policy rates higher. Growth would slow, unemployment would rise, and corporate earnings would decline. And in the shadow of the recent market failures in U.K. gilts and gilt repurchase agreements, we warned that the lagging impact of tighter policy would raise the risk of breakages in the system.

Job markets in the developed economies have remained strong, but otherwise these macroeconomic views have so far proven sound.

As such, we anticipated further yield-curve inversion. We thought the decline in earnings would be shallow enough to leave credit defaults low for the time being, but deep enough to test the recent lows in equity markets. That led us to an overweight view on cash and investment grade bonds, a neutral view on high-yield bonds, and underweight views on all equity markets.

U.S. and European benchmark yield curves have become more inverted, defaults have remained low and credit has performed well. But equity markets have also performed well, and beyond our expectations. The MSCI All Country World Index was up almost 10% by the end of January and finished the first quarter up 7.4%.

The Committee elected to remain underweight equities this quarter, and so the first question we asked ourselves was whether we were missing something about the current environment—something that might justify rising multiples even as earnings decline. Are we missing an opportunity to be more positive on risk?

A closer look at equity market performance suggests the outlook isn’t as positive as the headline index returns suggest. Strip out U.S. large-cap growth, and especially mega-cap technology stocks, and returns have been modest this year.

This was an outcome we did consider last quarter, when we noted the potential for re-leveraging by algorithmic trading programs, short-covering, and tactical buying of the big losing sectors from 2022.

But there may be more to it than that. Were investors taking a recessionary signal from the extreme inversion of Treasury yield curves, perhaps even anticipating the shocks to the banking system and subsequent decline in Treasury yields that occurred in March?

U.S. Tech, Driven By Falling Short Rates, Has Kept Equities Afloat This Year

 

Credit conditions were already starting to tighten before the current stresses in the banking system, and they are now likely to deteriorate meaningfully, bringing forward central banks’ objectives on tightening financial conditions. Put simply, the tightening in credit conditions may do the central bank’s job for it and necessitate fewer rate hikes. Push that logic further and assume a return to quantitative easing as a result of this weakness, and it might make sense for technology and other growth stocks to be bid up to higher multiples than more value-oriented and cyclical stocks.

This would not be a pro-risk signal, therefore, but a pro-duration signal.

That would be a rational market response. But the AAC still thinks it is wrong.

Throughout the current policy-tightening cycle, we have been wary about how vulnerable the economy might be to the lagged impact of a rapid move to positive real rates. For many years, now, business models and financial structures have been built on foundations of negative real rates and low interest-rate volatility. The U.K.’s pooled liability-driven investment products for pension funds and Silicon Valley Bank’s deposits-to-assets duration mismatch are among the structures that have been tested to failure so far.

How might this increasingly evident vulnerability affect central banks’ inflation-fighting strategy?

We do think the disruption has shortened this rate-increase cycle. Absent a further shock, however, we still do not believe there is a strong case for pricing for U.S. rate cuts in 2023, and beyond that horizon, we think the Fed is unlikely to settle below a 3% nominal rate, or a zero real rate, over the coming cycle. While inflation is likely to decline slowly over the coming months, we believe it will ultimately settle higher than we became used to after the GFC, with greater volatility, due to structural forces of de-globalization, rising labor power and the transition to a low-carbon economy. We see little prospect of a return to anything like the zero-rate policy of the period following the Global Financial Crisis (GFC), and while the Fed’s new Bank Term Funding Program could be characterized as a “QE-lite” response to current concerns about financial fragility, we see almost no probability of a fully-fledged return to quantitative easing.

While the economic conditions have the potential to be worse than this in the eurozone, recent communications from European Central Bank (ECB) members continue to highlight that further work is required to tame inflation. We therefore believe the market is over-optimistic on rate cuts here, too.

Against this background, it’s difficult for us to see a repeat of the long period of outperformance by long-duration assets, including large-cap growth stocks, that occurred between 2009 and 2022.

Every Committee member anticipates an equity market trough this year—it’s just a question of whether there’s another leg higher to come before it happens. In the immediate term, much depends on the potential severity of the current banking stresses (see “Up for Debate: Is the Banking Crisis Over?”), the looming risks in commercial real estate and the Bank of Japan’s policy normalization, the fragility of investor sentiment, and the question of when the equity market will finally accept that rates are unlikely to be cut in 2023.

That is the main reason why our overall view on the asset class remains underweight across every category. Just as important, investors are being very well compensated to sit on the sidelines and await more certainty. Short-duration high yield bonds currently offer a yield of 9%—at a fraction of the risk associated with equities over the coming months, in our view. Short-duration investment grade is yielding around 4.9%. Attractive rates have made cash one of the Committee’s highest-conviction overweight views this quarter.

What doesn’t come across in the Committee’s current “dot plot” of asset-class views is our belief that the banking crisis has brought us close to the peak in the Fed rate-increase cycle, and that therefore we think it may be time to start planning a journey back to a more neutral stance on risky assets—even if it’s not yet time to start taking risk. This might mean identifying the equity valuation and credit-spread levels where investors would be comfortable re-entering the market as it goes through trough-formation, for example. This is another reason why we think it makes sense to remain liquid right now, in short-duration fixed income and cash.

Furthermore, when the AAC is ready to upgrade its views on equities, it is almost certainly not going to favor the U.S. large-cap technology growth stocks that have led markets so far this year. Given our long-term views on inflation and rates, we believe a structural bias to value and quality as well as regional and size diversification is more likely to suit the next cycle than the U.S. large-cap growth stocks that benefitted from the last cycle.

In private equity and debt markets, the Committee’s views are more urgent. We believe now is an opportune time to deploy capital selectively, and our views have been strengthened by the recent banking-sector stresses and the consequent tightening of credit conditions. (A downgrade for our view on private real estate reflects highly divergent prospects for different sectors of that market—see “Up for Debate: Opportunity Set or Bear Trap?”.)

We continue to believe this stage of a cycle is generally the most attractive time to make private equity commitments. While declining rates may not drive multiple expansion to the extent that it did in the last cycle, investments made during a downturn still have the advantage of starting from a relatively low base.

Within private equity, we think secondaries is the most attractive opportunity right now. Pricing on legacy assets that investors intend to hold are likely to be marked down quite modestly, as owners ride-out the downturn—but there is not the same coyness in the secondary market. Here, pricing has become more buyer-friendly. This reflects a need for liquidity among investors, a shortage of secondaries capital and a growing shortage of the financing required to hold onto some assets (which is likely to worsen further due to the stresses in the banking system). Attractive co-investment opportunities have been appearing more frequently, too, due to the same squeeze on financing and liquidity.

Private debt and specialist capital solutions offer even more direct exposure to these dynamics. Tighter financing conditions are pushing terms and yields in favor of private direct lenders: double-digit first-lien yields from high-quality, moderately leveraged companies are increasingly available. Moreover, floating rates and a position high in capital structures provide a welcome buffer against what we consider the two major macroeconomic risks over the next six to 18 months: persistently tight monetary policy and declining corporate earnings.

We believe we are nearing the peak in the rate-hiking cycle. But a peak in rates is not necessarily a signal to take risk. The impact of higher rates comes with a lag, so the extent of that impact remains uncertain—current banking stresses could be the worst thing we see or just the start. As long as investors are being well compensated for staying liquid on the sidelines, we believe it makes sense to remain cautious—while planning the journey back onto the field.