Sometimes in investment you are wrong, sometimes you are early. As we all know, timing is a fool’s errand in investment
The real skill sits in the balance of probabilities and getting paid for the amount of risk you are taking.
Timing has been a particularly difficult thing to get right in the last few years as natural market forces have been replaced by manipulation, as authorities struggle to keep the plates spinning after events such as the Global Financial Crisis (GFC) and the Covid-19 pandemic. It has been a huge experiment in flooding the system with liquidity, to keep the lights on, and then dealing with the consequences. In the aftermath of the GFC and the unprecedented quantitative easing it provoked, the feared inflation response never showed up, taking the careers of many a seasoned bond investor and latterly ‘value’ equity market investor, with it.
Fast forward to the aftermath of the Covid-19 pandemic and the experience has been somewhat different. The contrast stems from the fact that this time liquidity entered the balance sheets of consumers, not banks. While many took the opportunity to reduce their debt, paying down mortgages, credit cards etc., the inevitable rise in the velocity of money in the real economy has had different consequences. Not least because this wall of money failed to find a home thanks to pandemic related shortages in supply. Ultimately, this inflationary pulse IS transitory – the difficulty is in predicting its timing.
Close to terminal?
We know that the global economy has surprised to the upside in the main with the US seemingly immune, so far, to the burden that inflation and a rising cost of debt bear. We also know that we are close to or at the peak in, interest rates. How? Because the data is showing us that enough heat has been taken out of the economy. The medicine is working. Inflation is moderating as are growth rates. This has taken longer to play out than many foresaw – terminal US rate expectations at the start of 2022 were 1.25%; at the December 2021 Federal Reserve meeting, the median expectation was for a peak of around 1.8% at the end of 2024. What was not appreciated at that point was how long the medicine was going to take – higher rates only take the heat out if they actually remove liquidity from the system and with corporate debt maturities fixed, mortgage rates locked in at ultra-low rates and the consumer still being supported by their Covid-19 stimulus cheques – the timing was off as was the volume of the move.
The risk inherent in equities is higher as the cost of capital rises. Growth companies rely on future earnings to justify their prevailing worth, and inflation and the cost of debt will eat away at this. ‘Value’ equities have a more immediate reference point for establishing their worth. This is centred around what a business is valued at in the present, based on tangible measures such as cashflow. The duration, or sensitivity to interest rate and inflation, is vastly different. To this effect, there is an opportunity within the equity space. However, equities are ultimately more complex than bonds in looking for an effective way to play where we are in the interest rate cycle.
Table Mountain or Matterhorn?
There are two key prongs to the argument that bonds are a better risk/reward allocation than broad equities. Firstly, if economically things get tricky being in government guaranteed assets feels like a comfortable place to hide, particularly when you are getting a real yield i.e., an income over and above a rapidly falling rate of inflation. Secondly, interest rates are likely to fall, even if the timing is unknown. There is presently much talk of a ’Table Mountain’ path for interest rates, where the terminal rate will be held for an extended period. This would break with convention to the historical norm. Rates have usually begun to come down around six months after reaching their terminal rate because by that point a central bank can see if its hikes have been effective.
We have not witnessed, at least in recent history, a period when rates have stayed on hold at the terminal rate for an extensive length. And although central bankers in the US, eurozone and UK are forecasting this will happen in the present interest rate cycle, history shows central bank forecasts to frequently be very wide of the mark. We, therefore, believe it is wise to exercise some caution in the credence we attach to their expectations for growth, inflation and rates even if others in the financial markets appear unable to break the habit of hanging on every word from Jay Powell, Christine Lagarde, Andrew Bailey and others. History does indicate that once evidence of a significant and sustained slowdown in the economy or stresses in the financial system emerges, interest rate cuts will surely follow.
The first cut could be the deepest (in impact)
Whether we get a hard, soft or no (what even is that?) landing, what we do know is that we are nearer to the end than the beginning of the rate hiking cycle. Inflation is easing, and while the rate that it falls to remains much in contention, the trajectory is clear.
The rapid rise of rates that we have encountered in the last 18 months is as unusual in its ferocity as it is muted in its impact so far, and one can only assume that these two factors are linked. With this in mind, we think the return potential of bonds, and related long-duration assets, is attractive. Many of our managers share this view. Hence this is a position we are sticking with for the moment, having been early but hopefully not wrong, so far in 2023.
