Barry Gill Evan Brown Anna Findling Jonathan Gregory Scott Dolan Jeremy Zirin

The theme this quarter is 'The Return of Yield: Opportunities and Risks' and the session kicked off with Evan Brown, Head of Multi-Asset Strategy, delivering his team’s macro and asset allocation outlook. Then Anna Findling, Head of Fixed Income Investment Specialists, hosted a discussion on the opportunity set in fixed income with Jonathan Gregory, Head of UK Fixed Income, and Scott Dolan, Head of US Multi Sector Fixed Income. Jeremy Zirin, Portfolio Manager in Private Client US Equity, shared his thoughts on how to find yield in equities. Finally, Barry Gill, Head of Investments, was joined by James Aitken, Founder and Managing Partner of Aitken Advisors, to discuss the risks to markets from the repricing of rates. What follows are the highlights of the discussions:

Quarterly Investment Forum Q4 2022

Macro Outlook

Macro and Asset Allocation Outlook

Evan Brown, Head of Multi-Asset Strategy

  • Our view is that investors are going to be surprised with the resilience of the US economy, particularly the labor market. Yes, activity will slow, but not by as fast or as much as investors are anticipating. It’s too early to trade the 2023 recession view.
  • This is not necessarily a good news story for risk assets: a more resilient growth outlook means it’s more difficult for inflation to come all the way down to 2%, and will keep the Federal Reserve with a somewhat hawkish bias. Interest rates have been tight enough to weaken housing, but it’s not obvious enough they’ve been high enough to weaken the labor market. Aggregate labor income is still running well above last cycle, and that needs to slow a lot to get spending to moderate and services inflation ex-shelter lower, which is what the Fed wants to see. Another key positive factor for consumer spending is the round-trip in gasoline prices, which is supporting real disposable income.
  • Headwinds for the global economy in 2022 are likely to turn into tailwinds next year. In Europe, consumer sentiment, the current account, and manufacturing activity are all showing signs of stabilizing or getting less bad. Countries have been reasonably successful in sourcing gas so industrial production may not fall too much through the winter.
  • But the big shift is on China’s reopening. Policymakers have pursued reopening much faster than expected, whether because of protests against the continuation of zero-COVID-19 policies or a need to prioritize economic activity to get more tax revenue to support policy goals of common prosperity and dual circulation. There are still concerns about ICU capacity and vaccinations, so the process of reopening may not be smooth but the direction of travel is clear. China is also providing liquidity in a more meaningful way to real estate developers, which should help put a floor under property sector activity.
  • On markets, we believe that fixed income is back, particularly in the short end. That being said, we think it’s premature to price in interest rate cuts from the Fed next year because there is likely to be a more resilient economy. The risks are for higher yields, not the cuts starting in the middle of next year that are currently priced. Short-duration investment grade credit is also very attractive here. The all-in yield hasn’t been this high since before the global financial crisis, and with an inverted yield curve investors receive the same yield but with less duration risk.
  • In equities, we see the choppy range continuing because of a tug of war between earnings holding up better than feared in light of economic resilience versus the Fed capping equity valuations. The volatile range means that active management, stock selection and tactical asset allocation will be increasingly valued as a source of alpha. The “higher for longer” environment we expect means that despite growth stocks de-rating this year, value stocks should continue to fare better, in particular financials and energy. Regionally, Japan is an interesting cyclical play, and we prefer emerging market to developed market equities. Among defensive sectors, we prefer health care, which is less expensive and yield-sensitive than utilities or staples.
  • We think the US dollar has peaked. It has been expensive for a long time, and now has a catalyst to reverse – a more balanced global economy, with China and Europe bouncing back and the Fed closer to the end of its tightening cycle. China’s reopening should also provide a boost for commodity prices, in our view.
  • That’s for the next few months, but what about the next several years? Our five year expected returns across major public asset classes have improved meaningfully compared to mid-2021, especially in fixed income.

Fixed Income

Opportunities in Fixed Income Markets

Jonathan Gregory, Head of Fixed Income UK
Scott Dolan, Head of US Multi Sector
Anna Findling, Head of Fixed Income Investment Specialists

Anna: The US has been the epicenter of the sharp move higher in interest rates. Recently, you became more constructive on US duration, and covered a short position. Why? What are your high conviction views?

Scott: The high starting point for yields coupled with the range of likely outcomes for next year make it possible to make a fundamental valuation call on fixed income. A soft landing or shallow recession are most likely, in my view, and in either of those, fixed income does well.

In credit, we could get price appreciation both from rates moving lower while credit spreads come in if a soft landing is priced. Suddenly the returns on longer-duration fixed income benchmark could be in the 8% to 10% range, with the downside capped somewhat by the cushion provided by the higher coupons on offer right now.

Jonathan: Where do we like yields around the world? The US front end is one of our favorites, as it has a lot of embedded protection if inflation is stickier than expected. We also like other markets where real yields are relatively high, like New Zealand, and don’t like places where real yields seem too low, like Japan and the UK.

Anna: What happens if inflation stays higher than expected, and central banks aren’t willing to follow through on fighting it?

Scott: That’s not our base case, because we’re already seeing monetary policy working to cool growth and inflation. Even in emerging markets, economies were much more prepared for this rise in the US dollar compared to previous economic cycles. The Fed has really struggled for credibility by starting its tightening cycle so incrementally. Now they’re getting that back, and we’re clearly seeing demand destruction. Monetary policy works with a lag, so more of this tightening impact is still to come. We don’t see inflation as a big risk, especially based on where we currently stand from a valuation standpoint.

Jonathan: I don’t think inflation gets out of control, though there are structural factors that can keep inflation above target: fiscal policy, demographics, decarbonization. It’s highly likely inflation has peaked, but there may be a challenge if we’re stuck at 4-5% inflation but it’s tricky for central banks to get much lower than that. In spite of this, I’m still bullish on bonds because of an earlier point: a 4.5% yield on the US 2-year Treasury gives an enormous cushion.

Anna: When is the time to add duration?

Jonathan: I tend to scale into positions and add as valuations become more attractive, which is just what we’re doing now. More critical than timing is diversification: you can survive bad timing but not bad diversification. That’s something UK investors found out recently in owning gilts, which weren’t a risk-free asset on a market to market basis.

Anna: At the asset allocation level, what are your thoughts on the stock-bond correlation moving forward?

Scott: Bonds will return to offering a portfolio ballast. There are strong demographic trends favoring fixed income that are still in place. Fixed income at these yields stands as an anchor in portfolios and should be less correlated, with a negative correlation likely to become more pronounced if risk assets do poorly.

Jonathan: Bonds will provide a good hedge if you own bonds in places where governments are fiscally credible, and central banks are credible in fighting inflation. If you own bonds in countries where that’s not the case, however, bonds may not be your friend.

Market Risks

Risks to Markets from Repricing of Rates

Barry Gill, Head of Investments
James Aitken, Founder and Managing Partner of Aitken Advisors

Barry: Is there as much risk as 2007 in the financial system?

James: The big difference is where the risk is. Back then, it was on bank balance sheets. Now, it’s with non-bank financial institutions—that’s where the leverage is. Also, the leverage is not resting with households – it’s with corporates. Reverse engineering this, the next crisis in the plumbing of the financial system is likely to be corporate obligations owned by non-bank financial institutions.

Barry: I remember running through what the sources of revenues were for ratings agencies to try to get a handle on where financial vulnerabilities might be. And before the housing crisis, it was all in structured products, now the growth has been all on the corporate side. Looking at areas such as liability-driven investing (LDI) and FTX, the cryptocurrency exchange, they are related in that now we are seeing the tide going out, using Warren Buffett’s verbiage, and these are just the first nude swimmers getting exposed. Do you see the market dislocations arising from liability-driven investment strategies in the UK as an isolated phenomenon or not?

James: That market episode was a metaphor for higher realized volatility, higher interest rates, and certainly, certain strategies overstaying their welcome.

LDI was founded upon rates being predictable and low, and using that dynamic to set up derivative structures that allowed pensions to take more risk on the asset side. These got bigger and bigger and weren’t tested at all until rates started really rising a lot. In Q1 it became clear that these strategies were running down their required collateral buffers on these derivative positions.

In September, all then-UK Prime Minister Liz Truss’ fiscal plans really did was knock everything over. So these strategies had to sell a lot of money-good assets to raise funds, and prepared investors on the other side were able to take advantage of involuntary deleveraging.

What else out there looks like LDI? My answer would be: nearly everything. After 20-25 years of low and predictable inflation, monetary policy became predictable, and realized and implied volatility became low. If all that happens, everyone is incented to take on leverage, and leveraged duration. After time, investors added a dollop of illiquidity on top of that. And now we’re seeing signposts that things are changing.

Large allocators are asking two questions: What do I need to do to not end up like UK pension funds? And if the two-year US Treasury yield is 4.5%, do I need to be taking as much risk?

Barry: The great irony of the LDI fiasco is that pension funds are better positioned today, because they can now buy bonds at higher yields and the present value of their liabilities has dropped.

James: Yes. The larger point is that an asset allocator looking to hit a 7.5% return bogey may be able to get there these days with an 80% to 85% fixed income exposure and balance in riskier or alternative assets, which is a complete inversion of the past 20 years. We’re not going to unwind that in just a couple of months. This isn’t necessarily bearish – it’s just different. Good assets held by weaker hands at wrong prices will be transferred to longer-term investors happy to create liquidity.

Barry: I spent a lot of time looking at the subprime market, and it played out in a five-act play. If we’re talking about this current shift, it seems more like we’re still in the first act. We don’t seem to have a massive forced deleveraging taking place at the moment. But who’s the next nude swimmer, to continue the Warren Buffett quote?

James: Likely to be in non-bank financial institutions, on the buy side in particular. Look for places that haven’t upgraded technology to optimize internal liquidity. Asset managers who have grown by bolting together different businesses may be most vulnerable. The key point is that risk has been transferred from the regulated banking sector to non-bank financial institutions. Be laser-focused on that.

Barry: We know the World Cup is going on, and that got me thinking about how Spain invented tiki-taka, a style of play that mesmerized their opponents and led to great successes on the international stage.But then everyone figured it out. They’re still making a thousand passes, but with no ability to get the ball in the net. To bring this back to investing: How long does the Fed have to keep rates high, along with inflation remaining high, before people realize that the game has changed?

James: It’s very hard to unlearn things: and if we were conditioned to learn anything over the past 20 years, it’s that if equities retreat, central banks will bail investors out because the risks were tilted towards inflation undershooting target. We’re not in that world any more. I struggle to see how we can be as confident as markets are today that inflation will converge smoothly back to 2% without weakness in the labor market.

A big difference between this tightening cycle and previous ones: if the central bank is committed to keeping rates high as the economy slows, then it is incrementally tightening policy. For all the tough talk from the Fed, and sporadic tightening in financial conditions, a reason why markets continue to do well and the US labor market continues to do well is because real interest rates are still negative. Give it three months, and things will be very different.


How to Find Yield in Equities

Jeremy Zirin, Head of Private Client US Equities

Over the past 100 years, dividends have accounted for roughly half of returns from stocks in any given decade. In the 1970s, the last time the US economy had a major inflation problem, dividends contributed well over half of returns.

Regimes in which inflation is high and declining and growth is weaking are typically positive for dividend companies. In this environment, the most preferred are companies with above-average yields but also with dividend growth and consistency. On a sector basis, banks and energy, along with some more defensive sectors, tend to display these characteristics.

Over the past 12 months, we’ve seen more interest in income-oriented strategies. People are identifying that this is a regime shift at play – not something that might just work on a tactical basis for a few months, but perhaps over a period of years.

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