In the run-up towards a FED policy rate lift-off over March, DM financial markets are following a recognisable pattern. Monitoring the return profile across the Bloomberg Eurozone and US Equity-Fixed Income 60:40 index, one observes a series of negative monthly return prints before and just after the start of a US-led monetary policy rate hiking cycle. Last year, both indices already tripped over the month of September, the moment FED chair Powell pivoted from a temporary inflation narrative to a persistent inflation problem and again over November 2021, as market participants adjusted the hiking intensity over 2022 towards 3 to 4 hikes.
Over January, consensus crystallised on a March lift-off, a ceasing of the active QE asset purchases program and swift arrival of FED balance sheet contraction (Quantitative Tightening) activity. That proved a sour cocktail, leading to a pronounced sell-off across US real rates. As expected, upside pressure on real rates led to a painful adjustment across equity especially within technology and healthcare. The Nasdaq index has been pushed into corrective territory, ending last week at -12% year-to-date. The banking sector benefited till mid-month, getting a lift by as much as +12% for the US KBW Bank index. Again, sobering US bank results over the past week wiped these out. US long-term inflation expectations are dropping steadfast. 30-year inflation expectations, as priced through US inflation-linked bonds, closed at 2.22%, a mere 25bp above its 5-year average.
In the meantime, the US 60-40 index took a dive towards an uncomfortable -5.63% since January 1. The EU 60-40 index sits at -1.43% thanks to less technology presence across large cap names. Investor nerves are tested. Interestingly, when we opt for a 6-month lookback we stomach a -1.58% on a US 60-40 portfolio in USD terms. The EU 60-40 portfolio manages to eke out a +0.55%. Dixit Warren Buffet: “In the short-term, the market is a popularity contest. In the long-term, the market is a weighing machine.”
Staying with these same traditional portfolio mixes, it deserves mention that, through the December 2015-December 2018 FED hiking, the 60-40 portfolio stood its ground, posting annualised local currency returns of +2.65% for the EU and +7.15% for the US. They did exhibit flat performances over the first three to six months into the hiking cycle, as participants lacked visibility on the length and target terminal rate the FED aimed at. Expect a similar attitude this time around. Expect markets to dwell without clear direction over the first half of 2022.
Market gyrations are common to pre-hiking cycle episodes extending into the early phase of monetary tightening. Market participants seek or are forced to adjust their portfolio construction and diversification profile.
Investors should try to belong to the first group i.e. those that actively seek to adjust their portfolio with knowledge and intent based on a bottom-up screening of present and future valuations across fixed income and equity sectors. This time around, maybe a first, the decision on weighing DM versus EM fixed income and equity risk presents itself as the defining one. Crossing the Rubicon and pulling the EM card with conviction might become the winning hand. Finally. Effectively post GFC (Great Financial Crisis) DM markets offered high quality returns with few hiccups. Within EM returns, hiccups were the common thread. With the pandemic still ranked high across potential market-disturbing risk factors, calls in favour of EM investment opportunities might sound less responsible. Yet, it’s always darkest just before dawn. EM LC Government Bonds post an attractive yield just below 6.00% and year-to-date returns went counter to DM rate and credit returns over January. EM debt local currency popped into positive territory last week! EM central banks were pre-emptive across respective reaction functions and hiking cycles are already, on balance, well advanced. Inflation expectations start to get under control. And yes, market consensus around terminal rates for several EM central banks come into view. Robust portfolio construction is all about finding exposure to a maximum number of independent risk factors that hold value. With a challenging investment episode ahead of us, EM valuations attract and deserve close attention. The economic-policy-induced correction across Chinese equity markets with contagion across Asia deserves closer scrutiny, attention and investment interest.
When you belong to the second group of investors i.e. being forced to change portfolio construction, the stars get misaligned. There is nothing wrong with drawdown management. Still, our duty is to invest successfully over the long-term. Investors get forced to alter portfolio construction because they opted for too narrow conviction calls or they decided to invest on margin.
Rotating pre-emptively into sectors that behave better under tightening financial conditions is a call that should already have been made. Early 2021, when inflation worries were not the main narrative, it already became clear that over 2023 the FED and (potentially) the ECB would have initiated a policy rate hiking cycle. Holding onto a narrow set of winners in technology or growth stocks was bound to be subject to corrections. Gravity is a law in nature but also in finance. Often, stressed margin investors are behind periods of increased financial market volatility. On top, smart prime brokers are aware of such pressure points and profit from them. For less astute prime brokers it can become an existential threat.
This piece is not a call for complacency as we enter a monetary tightening cycle. On the contrary, it is a call for vigilance. Vigilance to apply and respect proven investment processes that allow you to look through the hiking cycle.
