With half a quarter to go before H1 2023, the results are in and investors nerves might start to loosen up. Over the past week, it became increasingly likely that US terminal policy rates have been reached at 5.00%-5.25%. The April US inflation data set provides the FED with arguments for a pause come next FOMC meeting on June 14. Interestingly, the next US inflation batch for May will hit the screens the day before on June 13. If YoY US headline inflation at 5% versus core inflation at 5.5% might still cause discomfort, the headline MoM reading of +0.4% takes the 3-month annualised rate down from 4.07% to 3.66%. Expect housing inflation to start cooling leading to US inflation readings around 3.00% by year-end.
In the meantime, performances across equity and fixed income sectors chug along. Fixed income portfolios put in results that reflect the embedded carry. Investors are impatient and still have to get rid of the 2022 trauma. Yet, over the past 12 months the average print on US 10-year rates was 3.44%. Last Friday, 10-year US rates closed at 3.46%. The average print on the 10-year German bund was 1.90% over the past 12 months. 10-year bunds closed at 2.27%. Forwards on 10-year benchmark rates over the next 1 to 5 years reveal ranges from 2.25% to 2.75% for Germany, and 3.40% to 3.90% for the US. Fixed income performances across sectors print between +1.50% to +5.0% YtD. Emerging market (EM) local currency government bonds take first spot. European equity scores double digit returns. In the US, tech stocks rerate on AI excitement.
Going forward, the standard narrative will centre around the level at which policy rates will settle the moment respective central banks try to steer for an equilibrium between growth, inflation, and unemployment. Anyone up for 3.00 long-term US policy rates versus 2.00% on the ECB side? That’s an approximate increase of 50bp compared to the pre-COVID consensus. However, hoping to see such equilibrium policy rates anytime soon might remain elusive given geopolitical fragmentation. Then again, one has to face reality and seek inspiration looking at what happens beneath the surface. Such an exercise might be a basis that leads to a rebalancing of portfolios over the next investment cycle. A rebalancing that proves necessary in order to beat traditional (European) model portfolio benchmarks. Typically, such model portfolios allocate between 50% and 75% to EU government bonds, European IG credit and equity.
We’ll briefly touch on three factors that will play out on a longer term horizon but that require attention today. The first concerns regional preferences. How should the balance between OECD versus EM assets in portfolio construction evolve? The second invites investors to make a call on the USD hegemony i.e. a currency call. The third relates to sectoral investment success or the importance of selecting winning business models in economies adapting to climate change. Spending too much time on identifying resilient companies transiting might prove to be suboptimal.
Investors are advised to carefully consider the relative, at times absolute, impact of commodity, value chain or energy dependencies faced by OECD countries. Fragility to demand-supply disruptions, related twin deficits balance of payment risks and anaemic export growth can hit economic growth potential across the EU but can also impact the US manufacturing and service industries. Activist monetary and fiscal policy recipes, that have served us well in deflecting the impact of pandemic and energy stress, might become less effective the moment trade flows are destabilised in a politically fragmented world. When companies cannot fully pass on higher input and energy costs to the consumer, the fabric of western economies weakens. Trade and current accounts fall structurally into deficit. Fiscal competition between the EU and the US, symbolised by the stand-off between the EU’s Green Deal Industrial Plan and the US Inflation Reduction Act, might harm credit risk ratings on both sides. On reflection, the outlook for developed (DM) markets could pale compared to the opportunities detected across EM markets. DM dependencies on Asian markets for semi-conductors, raw materials and batteries are substantial. EU dependencies on energy supply from the US and the Middle East have risen sharply as we phase out Russian imports. Protectionism is growing. Protectionism does not rhyme with free trade of goods and services and resulting disinflation. Emerging markets might have more cards to play if institutions and companies are allowed to thrive. Political stability and reliable rule of (local) law are key ingredients. Research on the impact of increased weights across hand-picked emerging market government bonds, credit and equity should receive a lot more attention (and courage) from investors today.
A second, under the surface, current that might gain strength is the demise of the USD hegemony as a main global reserve and trade currency. The USD share of total global reserves in real terms has declined from about 66% twenty years ago to 55% in 2021 and 47% by the end of 2022. The US-led series of sanctions, following the Russia-Ukraine war, pushed many foreign central banks to off-load USD-based assets. The sale of liquid US Treasuries stands out in this respect. And no, other reserve currencies (Euro, Yen or Yuan) did not profit from this reality. The big winner has been gold. Even as the USD remains the main transaction currency, one can detect that its supremacy is waning. The USD rose to dominance as an asset-backed global currency till Nixon abandoned the gold standard in 1973. Even though the USD became a fiat currency, backed by the credibility of the US central bank, its hegemony endured. However, a series of initiatives at the level of the BRICS countries (Brazil, Russia, India, China and South-Africa), comparable to the G7, could give way to the formation of a new commodity-backed currency. Earlier this year, China and Brazil agreed to replace the USD to settle certain trade flows. India has also offered countries that face a lack of USD liquidity to opt for Rupee settlements. Watch the space.
Previous musings touched on the necessity for companies and governments to transform strategy or public policy direction in order to mitigate and adapt to climate change impact. Clean energy sourcing, as a main input factor, will grow as a defining comparative advantage across industries, including commodity and material sectors. Green commodities, produced through clean and eco-neutral methods, will become mainstream. Transportation industries are accelerating their transformation. Companies that actively manage their asset portfolios with a 10-to-20-year horizon will stand out. Financial sectors are bound to get disrupted as well. Analysts will scrutinise financial services actors, from banks over insurance to fin-techs, closely in order to invest in those that prepare and build the next generation service models characterised by instant, reliable and customer friendly experiences.
Combining above the surface events with below the surface currents is not an easy equation to solve. Paring the trio of above undercurrents with valuations across currency-, rates-, credit- and equity-markets can lead to surprising conclusions. Time to reflect and possibly test new asset allocation paradigms. Good luck.
