Many leading economists and market professionals believe that we are now in the early stages of a cyclical change in the economic landscape, following three decades of low inflation and shrinking interest rates. It's a challenging time for investors.
This article is an examination of the potential scenarios that are likely to materialise, what they mean for investors and how Dynamic Asset is responding to the risks and opportunities.
This article is intended to help WLM clients to remain informed, but please note that it is technical. Please contact us if you would like information or advice.
US stocks have just seen a 2 month long 20% rally off their lows, which are very average metrics for a bear market rally. Long duration technology stocks and lots of the old meme and other rubbish (loss-making) stocks led the charge in a short-covering rally that almost no one with any fundamental research outlook fully participated in, including us.
Stocks are now at a critical point where they either roll over, potentially even testing new lows in months ahead in response to a market or geopolitical crisis, recession or stagflation or they go on with a new bull market in response to central banks becoming more dovish and giving up the fight against inflation.No one can predict the future, so we have to consider both scenarios. Which will it be?
Everyone likes a good story, and many want to believe everything will be sunshine and roses going forward, including the industry participants that benefit from promoting this outcome.
If there is to be a new bull market, then the most significant factor by far will be central bank policy. That is, believing that central banks will pivot back to easy money, inflation will ease enough for central banks to claim their job is done without the need for further aggressive interest rate rises and/or that central banks and governments will accept a higher inflation target to avoid a recession and higher unemployment.
Note: In classic economic theory, in the absence of running the economy well, the latter of which we have seen no evidence of in recent years, ultimately, inflation needs to be moderately higher to wear away the debt bubble. For this reason, and because politically pressure will be on to look after the workers in the economy, we believe there will be a policy shift - eventually – it is merely a matter of timing.
The challenge with expecting a new bull market today is it may be too soon to declare that outcome likely, or even plausible. Inflation of 2% (or even <4%) isn’t coming any time soon to the US, Europe or many other places, including Australia. The FED and other central banks require more time or more aggressive policy to see if inflation will get there. At a headline rate US inflation may indeed continue to fall from here as the economy weakens, and mathematically we’re coming off-peak rates, but inflation is highly likely to remain well above its target rate on average, and volatile for months (if not years) to come. If history is any guide, and central banks are serious about reigning in inflation, this will require further meaningful interest rate increases, as inflation has never become contained historically without interest rates exceeding the inflation rate. As we are nowhere near this point currently, the case for a new bull market today appears fragile unless you strongly believe central banks will meekly roll over (which is possible, but is a gamble).
In the short-term, the case for such a quick and aggressive new bull market appears flimsy. Ultimately though, we believe it is eminently sensible to question whether today’s central banks have the backbone or credibility to adequately crush inflation by making policy truly restrictive over the medium-term. Our premise is that Central banks will ultimately, once again, err on the side of easy money, and will almost certainly do so in response to a financial or economic catastrophe. The question mark for us is more around the timing of this policy pivot. Recent market action suggests the market expects this is imminent and will not require a recession or crisis to get us there first. We think it will be hard for central banks to give up while inflation is so much higher than rates, so there may be further meaningful interest rate moves. As this works through the system, it seems highly likely to cause a debt-led recession or market accident. Ironically, once the central banks have created a problem, then the thesis for a new, sustainable bull market makes more sense. But we might have to wear some pain first.
Ultimately, at this point in time, being a bull involves betting against the FED, which historically hasn’t worked well over the medium-term. You have to ignore high inflation and all the tough central bank talk claiming they’re willing to stop inflation in its tracks. While the bulls may be correct over the medium-term, they risk being very wealth destructive on the way there and suffering meaningful further downside.
If economic rationalism is a thing anymore, the fundamental outlook suggests the bear market has further to go, both in time and potentially in degree. A “Bubble In Everything” isn’t simply corrected with a mere 20-30% fall and reducing high P/E multiples. Under a free and open capitalistic model it would require a big bad bear market to truly wash away the excess.
Many assets (e.g. Australian housing) remain hopelessly overvalued, profit margins remain excessively optimistic given cost inflation and the economic outlook and speculation have not yet really been extinguished. Many investors naively remain believers in the idea that property and stocks will always make 10% a year and in passive investing despite not having made that themselves and the outlook being poor! The geopolitical world order has rarely appeared more problematic – peaceful prosperity is dead - and deglobalisation and supply chain resilience, along with public policy directed by environmental and labour ideology rather than being market-friendly public will necessarily entrench higher inflation and lower market multiples.
By now, many are realising (but largely ignoring) that economies are unsustainable basket cases and that stagflation is already with us: inflation is high, but there is low real growth and disastrous productivity outcomes. But, in the real-world markets cannot be removed from productive wealth creation ad-infinitum and floated on a debt bonanza forever. Everyone has to pay the piper at some point. Regardless of central banks, for this reason alone, it is eminently reasonable for investors to expect years of lower returns and volatile markets. In this environment, passive investing is dead for a decade and only good active investing has any hope of success.
Put the case for a bull market and a bear market together and we think it is reasonable to expect that we will see a half-hearted but still punitive response to fighting inflation causing a market crisis and a prolonged bear market before central banks feel compelled to double down and entrench a higher inflation outcome.
Nominal growth could then be reasonable, but with higher inflation the reality is it will still be a low real growth outcome. In the short-term, the market may well flounder before a new volatile “Ponzi/fake wealth” bull market begins with economic, market and political outcomes eventually resembling those of an emerging (or submerging) market.
The economic and market outlook suffers from a high degree of uncertainty given its huge potential variability, dependence on policy and geopolitical outcomes. There are many sensitivities and tail risks to consider as a custodian of people’s wealth. At such times it is important to be humble and build greater diversification and resilience into portfolios – effectively preferencing resilience over maximum return or efficiency.
At Dynamic Asset we have reduced reliance on bullish market outcomes and have greater exposure to alternatives and active management, as these diversify our sources of returns. As an example, we carry meaningful weightings to alternatives such as long/short, market neutral and convertible bond strategies in our portfolio and prefer those ahead of simple passive stock and bond exposures held by many others, and which we believe are better suited to times past. In short, we’re carrying lower traditional equity and bond exposures in order to limit our risk to highly adverse outcomes.
Given it is more likely than not that we are entering a period of higher and more volatile inflation and that inflation is more likely to be structural in nature in the 2020s, we are also preferencing higher weightings to assets that do better in an inflationary environment, particularly those which have been and continue to be capital starved or have structural tailwinds.
These assets serve the dual purpose of also being favourable should further geopolitical and military conflicts ensue, which looks increasingly probable. As such, we are investing in real assets, including commodities, precious metals, energy sources such as uranium or more broadly investing in resource and energy stocks instead of financial assets. Given the war in Ukraine and the strong ESG push to reduce mining, oil and coal usage there is arguably an energy and commodity crisis in train. Energy prices around the globe are meaningfully higher and perhaps structurally so if capital markets persist with the current approach. It is therefore important to have reasonable exposure to these assets which have not been supported over the last decade but are nonetheless necessary to achieve societies objectives, including managing climate change and environmental goals.
By having a highly differentiated, more inflation orientated portfolios to the mainstream, we run the risk, but also the benefit, of performing very differently to others, particularly over shorter time periods. We are not trying to match the market and do what everyone else is doing. We are aiming to achieve our mandate outcomes, pure and simple.
An example of where our approach has not worked well for us in the short-term is gold and silver which have struggled with higher real rates, recessionary fears and a strengthening US dollar. But they are being held in our portfolio because of higher geopolitical risks including military risks and the risks of inflation and central bank capitulation over the medium-term. Uranium has struggled despite many fundamental positives including being an almost essential base load and transitioning energy source if the world is to be serious about reducing carbon usage, with significant supply/demand imbalance likely over time. Resources have suffered due to recessionary fears, but we believe have structural tailwinds and will benefit from capital scarcity following a decade of underinvestment and again a likely supply/demand imbalance over the medium-term. Given resource volatility and recessionary concerns we have expressed our resource view via a long/short manager which is quite nimble, and which owns a long position in Energy stocks.
We still hold some equities but have put in some equity hedges due to our view that the recent rally is most likely to be a bear market rally. As discussed we believe the recent rally was largely driven by short-covering with many non-profitable and speculative companies which we don’t own being the strongest outperformers (hence we didn’t benefit from these). Our equities have an Australian bias as we believe Australia has more favourable factors including demographics, an ‘old’ economy focus, that it is less likely to see very high interest rates due to the sensitivity of its overvalued property market. We have a modest bias towards areas of the market which we believe are more inefficient as there is reasonable selective value on offer and active management can add value here. For example, despite having reduced our exposure, we still own some value orientated microcaps. We have limited exposure to Europe which is likely to suffer more from major policy mistakes including its energy policy and the conflict in Ukraine. We also have limited exposure to growth stocks which we believe continue to be at risk from higher discount rates.
We’ve recently bought some – albeit modest - position in long duration bonds as valuations have improved somewhat due to increased recession risk. Contextually though, it is important to note that we remain significantly underweight to duration risk due to the major risk that inflation is more structural in nature, and that while inflation may come down it will possibly stay meaningfully above stated targets for longer than is being communicated.
We will be investigating new asset classes such as carbon credits as listed options become available to express a position in these.
In the short-term, we believe owning more real assets and an inflationary or stagflationary portfolio is prudent because economic and geopolitical risk is extreme and the risk of a continuing stagflationary bear market is high.
If a genuine crisis or recession ensues our approach will also provide us with the opportunity to become more risk on and increase equity exposures at much cheaper prices. If not, we expect a portfolio which is better aligned with inflation and stagflation should do relatively well regardless over the coming years - as real growth remains weak due to an aging population, mismanaged economies and capital allocation and disastrous productivity growth - and inflation proves more volatile than simply transient in response to poor public policy and ongoing geopolitical frictions.
We believe there is every need to respond to today’s economic and political risks and re-engineer and better align portfolios to the dominant risk and outlook and have hence done so. While this comes with the risk of short-term underperformance, we believe over the medium-term it is the most prudent path to take given our fundamental assessment of the risks and opportunities.
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The material and contents provided in this publication are informative in nature only. It is not intended to be advice and you should not act specifically on the basis of this information alone. If expert assistance is required, professional advice should be obtained