Summary

1 Macro momentum progresses well: global PMI surveys suggest positive Q1 growth. Europe continues to see relief from lower energy prices. But leading economic indicators and the bond market still predict a US recession later in 2023. We expect a modest US recession later this year, while Europe may or may not escape recession.

2.But markets price a tougher inflation challenge for central banks: ironically, good economic news has led markets to conclude that the Fed and ECB will have to raise rates further in order to curb inflation. Markets price higher peak interest rates, cooling investor optimism.

3.Further rate hikes to come: we forecast that the Fed Funds rate will peak at 5.25% in May. We expect the ECB’s deposit rate to peak at 3.50% in June. Presently, we see opportunities in eurozone short-term government bonds, given elevated yields (> 3%) and limited risks.

4.Stocks,  credit and bonds pull back short term, as expected: After an explosive rally since October, a mid-February pullback is typical, and sets up for a further market advance in March-April. Investors should profit from this pause to invest in corporate bonds and stocks.

5.Focus on alternative assets: a range of alternative assets provides potentially superior returns and diversification to long-term investors. We favour private equity buyout funds, infrastructure funds, trend-following and merger arbitrage hedge funds.

 

When good (economic) news is bad (market) news

 

Is the economy still running too hot?

Over the course of January and February, economic activity picked up in Europe, the US and China (see chart of improving economic surprise indices below). This improvement has reached the point where investors begin to hope that Europe and the US can avoid recession altogether in 2023.

To underline this more optimistic economic scenario: the Atlanta Fed’s GDPNow for Q1 GDP growth rose from less than 1% (annualised) in late January to 2.5% as of 24 February. In the euro area, better economic activity has been signalled by improving PMI survey results, with the S&P composite PMI rising to 52.3 in February (above 50 indicates a growing economy), against a low of 47.1 touched in September.

The bad news: hotter economy implies higher rates

However, there is a sting in this macro tail for financial markets. Stronger growth implies more difficulty to ease inflation pressures from services and particularly from employment (high wage growth).

This, in turn, suggests that central banks, such as the US Federal Reserve, will not be able to end their rate hiking cycle as quickly as expected, and may be obliged to raise central bank rates even more to tame inflation. This new expectation is reflected in a higher expected terminal rate (peak interest rate) of 5.3% mid-2023, sharply higher than end-January’s 4.8% level. This expectation of more Fed rate hikes has pushed the US 2-year Treasury bond yield up from 4.1% at end-January to 4.7% currently, equalling the peak 2-year yield reached in November last year. 

But negative market seasonality is normal

This move higher in interest rate expectations and bond yields has triggered a mild correction in the upward march in financial markets in place since October last year. The   Barclays Global Aggregate Index of sovereign and corporate bonds has fallen 2% since mid-January (in euros), while the MSCI All-Country World Index of global stocks has eased 2.5% from mid-February highs.

Bear in mind that the second half of February marks a seasonally weak span. Over the last 20 years, the US S&P 500 and German DAX indices have typically eased 2% and 3% lower respectively from mid-February to mid-March, before resuming a bullish trend until the end of April. So thus far, this pause in the bullish October-April seasonality trend is entirely normal.

Use pullbacks to add to stock and credit positions

For those who are still underexposed to stocks and corporate credit, this mini-correction may be an excellent opportunity to add in favoured areas such as European and Emerging Market stocks, and short-term US and Euro investment-grade credit.

• Resilient recommendations in assets which we would advocate buying include:
• European Value stocks (still cheap versus history),
• Luxury/branded goods (strong top-line growth),
• Short-term US investment-grade corporate bonds (1-3 year US IG credit now yields 5.4%), and
• Industrial metals exposure (copper, nickel, tin). 

A 2nd opportunity to buy bonds

Higher terminal rates trigger short-dated bond opportunities

No relief for central banks: the combination of sticky inflation, better-than-expected economic activity, resilient consumers and strong labour markets in both the US and the eurozone is telling central banks that their job of cooling down the economy is not done.

Higher estimates of end-of-cycle rates: interest-rate traders currently expect policy rates to peak at 5.6% in September in the US and at 3.9% in December in the eurozone. These estimates are high and not consistent with what policymakers are saying.

Our scenario for the Fed: we have revised up our estimate for the end-of-cycle rate to 5.25% from 5%. We now expect two more rate hikes of 25bp each at the next two meetings (March and May).

Our scenario for the ECB: we have raised our end-of-cycle rate to 3.5% from 3.25%. This implies a 50bp rate hike in March, 25bp in May and 25bp in June.

No rate cuts in 2023, in our view, from either the Fed or the ECB.

Opportunities in euro-denominated short-term government bonds, in our view

Elevated bond yields: the sharp repricing of the ECB end-of-cycle rate has pushed bond yields much higher, notably short-term bond yields.

Substantial buffer: the German 2-year yield reached 3.2% on 28 February. This provides a great buffer in the event of future adverse rate moves. An investment in this 2-year bond would only lose money if the 2-year yield were to rise to 5%.

Limited risk: the market is pricing another 145bp cumulative rate hikes from the ECB by December. It seems unlikely to us that the ECB would surprise and deliver more than what is already priced in. Hence, the risk of short-term bond yields rising significantly more is limited.

In conclusion, EUR short-term government bonds look a good tactical investment for conservative investors who are seeking attractive yields with limited risk.

Investment Conclusion

Sticky inflation and better-than-expected economic data will force both the Fed and the ECB to continue to hike rates. We think that the Fed will raise its policy rate until it reaches 5.25% in May. As for the ECB, we expect the deposit rate to peak at 3.50% in June. Strategically we are Positive on US government bonds. We are Neutral on government bonds in the eurozone as we expect better entry points in the coming months. Presently, we see opportunities in EUR short-term government bonds given elevated yields and limited risks.

Not the time to return to US mega-cap growth

Heed the lessons of the 2000 TMT bubble

The Nasdaq 100 technology-heavy index (the QQQ ETF) has rallied 19% since late December, marking the third such double-digit percentage rebound in US technology stocks since the QQQ’s peak in November 2021.

One of the key drivers of this third rebound has been increased investment by US retail investors, with huge daily trading volumes evident in recent weeks in “retail favourite” names such as Tesla. In spite of this, the Nasdaq 100 remains 27% below November 2021’s peak as of 23 February, while the FAANG group of mega-cap growth stocks are 33% below 2021 peak.

Moreover, fundamentals do not argue in favour of US tech – not only is the valuation still relatively expensive at 24x forward PE (compared with 16.9x average from 2010 to 2019), but aggregate earnings forecasts have been consistently falling since mid-2022 on the back of weaker top-line growth and increasing pressure on profit margins.

We would repeat the lessons from previous bubble periods such as the year 2000 – in general, the leaders in any new bull market are not the leaders of the previous uptrend. In the years following 2000, US small-cap Value was the leading investment style to gain, even as large-cap tech stocks continued to fall (bottoming eventually in October 2002).

In a similar fashion, we still see potential today for further outperformance by World ex-US Value stocks over US large-cap technology names. 

Even a modest US recession is bond-friendly

While we are economic optimists, even we believe that the financial markets have priced a too rosy an outcome for the US economy this year. The Fed Funds rate is likely to exceed 5% before mid-year, and we expect the lagged effect of prior interest rate hikes to apply the brakes to the US economy during the remainder of this year.

Under this scenario, US growth should fall into a shallow recession by Q3 2023, dragged down by a sharp contraction in interest rate-sensitive sectors, such as housing and construction, and big-ticket consumption. We look for US headline inflation rates to return to 3% or lower after mid-year, which would drive the 10-year US Treasury yield from the current 3.9% back down towards our 3.5% 12-month target.

The combination of  pressure on top-line sales from slowing growth, and on profit margins from stubborn wage inflation will hurt labour-intensive US sectors such as Construction, Leisure and Entertainment, and Retail (including Amazon). We thus avoid exposure to these US sectors for now.

But Europe may just avoid recession!

In contrast to the US, Europe benefits from an easing of the energy crisis and a less aggressive ECB rate hike cycle compared with the US. In addition, while some wage pressures are evident in Europe, they are far less acute than stateside. Consensus forecasts of quarterly 2023 eurozone GDP growth now show no negative quarters forecast, with improving growth in 2024.

All about Alternative Assets

The benefits and pitfalls of alternatives

Alternative asset classes are a set of alternative investments to consider in addition to the traditional asset classes of stocks, bonds, real estate and cash.

These include:

- Commodities

- Private equity

- Private debt

- Infrastructure funds

- Hedge funds

- Specialist strategies - investing in farmland, forests, art, insurance policies, litigation finance etc.

What benefits are there from Alternatives?

Capturing the liquidity premium: assets that are illiquid - i.e. not easy to buy and sell quickly and at low transaction costs - should provide a higher long-term return to investors, to compensate them for this lack of liquidity.

In general, the more illiquid the investment, the greater the liquidity premium that will be required to make it attractive alongside other, more liquid assets.  Private equity is a classic case of an illiquid asset class that has relatively high transaction fees, cannot be bought and sold with the same ease and at the same low transaction costs as listed shares, but which over time has generated superior long-term returns to patient investors.

In the US, private equity funds delivered a net 11% annual average return to pension funds from 2000 to 2021, according to alternative investment adviser Cliffwater. This was more than 4% greater than the 6.9% average return from listed US equities over the same period.

Diversification: Alternative asset classes are also included in investor portfolios for reasons of diversification - i.e. a zero or negative correlation with stocks and corporate bonds, helping to thus smooth overall investment portfolio returns in volatile years (such as 2022).

Hedge against inflation: real assets, such as commodities, infrastructure assets and farmland /forestry tend to have returns that rise with inflation over the long term. These alternatives can thus offer at least a partial inflation hedge in investment portfolios.

Investment Conclusion

Alternative assets can be a useful way for investors to generate real returns and diversify away from stocks, bonds and real estate. There are a number of benefits, but also pitfalls from investing in these alternatives.

Volatility smoothing

Illiquid assets can reduce behavioural biases

“Volatility smoothing” is one feature of many illiquid alternative asset classes, which can help to  lower the investment risk from behavioural biases. Simply put, investors in private equity, farmland or forestry assets for example, cannot “panic sell” these assets due to fears of economic downturn, as one can in stocks and bonds.

We should be clear - it is not necessarily that private assets in reality have lower sensitivity to an economic recession, but simply that prices are not set on a daily or even intraday basis by the market. Fund manager Pimco has observed that the true economic volatility of private equity is “close to 30%, rather than a headline number of 10%”. Solutions provider Burgiss suggests that the true annual volatility of private equity buyout funds is around 17%, similar to that of public equities.

Moreover, valuations of private assets are rather only recalculated on an infrequent basis (monthly, quarterly or even semi-annually) and often on the basis of “mark-to-model” rather than “mark-to-market”. This allows fund managers to smooth volatility of prices and returns even more. 

Potential pitfalls with Alternatives

What to be careful of

There are of course a number of potential problems and risks one should be aware of before investing in these alternative assets:

§ A long-term investing horizon is essential, due to the illiquidity of the underlying assets. Investors should not invest too heavily in private assets, keeping only a minority of their overall portfolio in these private assets.

§ Higher transaction and management fees: investment in private asset funds incurs higher entry and annual management costs than for listed equity or bond fund investments.

§ Manager selection is key: there is huge variability in risk and returns from different managers. Even if the “average” return of the asset class like private equity is impressive, your particular fund return may bear no relation to this average.

§ Opaqueness of underlying investments, strategy: investors should always understand what they are investing in - but this can be sometimes difficult for a number of complex investing strategies.

Investment Conclusion

The “smoothing” of asset price volatility that one sees generally in unlisted assets, combined with the relative difficulty of selling out, can act as powerful inhibitors to selling for investors who might otherwise sell out when the economic outlook darkens. This can protect investors, to some extent, from their own behavioural biases which can otherwise act to hurt their long-term returns - by selling at or near the lows, and buying at or near the highs.

Which private asset classes do we favour today?

Leveraged Buyout (LBO) private equity funds - able to benefit from the relatively low valuation of smaller-cap companies in today’s stock markets. The Bloomberg private equity buyout index shows a 12.5% annual average return for LBO funds since 2007. But, the higher cost of leveraged loans (debt) on the back of higher interest rates will inevitably reduce internal rates of return for private equity funds in future.

Infrastructure funds - energy, technology, regulated utilities, sustainability, security-related. There remains huge demand for infrastructure investment worldwide linked to a number of key themes - the race to zero carbon, the increased emphasis on European energy security, implementation of 5G mobile internet connectivity, and greater social infrastructure, such as social housing and healthcare facilities.

Since start-2000, the Global Listed Infrastructure Index from GLIO has risen from 100 to 809 in euros, for an average annual return over the 22-year span of 9.5%, more than double the 4.5% average annual return from the MSCI World Index over the same period. In 2022, while the MSCI World Index lost 18% in euros, the global listed infrastructure index gained 1%, outperforming both listed stocks and bonds. 

Trend-following hedge funds are a good diversifying complement to stocks and bonds, benefiting from a bumper 2022 as they were able to exploit strong and persistent macro trends in stocks, bonds and FX.

While trend-following funds have often shown modest performance when stocks and bonds are rising, CTAs (large trend-following funds) returned 20% in 2022 (according to the SG CTA index) while stocks, bonds and real estate suffered.

Merger arbitrage hedge funds employ another hedge fund strategy that try to profit from arbitrages that can appear in announced mergers and acquisitions of listed companies. Funds following this strategy tend to buy shares in the target company to be acquired, while selling shares of the acquisitor company.

This strategy tends to show a relatively low correlation with stocks and bonds over the long term, while offering far lower volatility as well.

Over the four years from 2019 to 2022, merger arbitrage funds returned an annual average of 6%, according to hedge fund data provider BarclayHedge. Note again that merger arbitrage strategies  managed a small positive average return in 2022. 

Investment Conclusion

For investors with a long-term investment horizon who are looking to devote part of their investment portfolio to alternative assets, we favour value-oriented leveraged buyout (LBO) private equity funds, infrastructure funds, and both trend-following and merger arbitrage hedge funds.