As asset allocators and risk managers, CIO looks to historical data, economic conditions and the behaviors of decision makers to guide their decision making. No two periods are identical but contrasting moments in time can be illuminating.
Across a number of indicators, the economic backdrop just months before the outbreak of COVID looks quite similar to today. US unemployment was below 4%, manufacturing activity was steady, and the yield curve was extremely flat. Equity valuations were about “average,” neither expensive nor cheap. And in 2019, concerns about a possible recession were growing.
There are significant differences between 2022 and 2019, as well. Oil prices are nearly double their 2019 level. Inflation is significantly higher than the Fed’s 2% target, spurring an aggressive hiking cycle and reduction in lending to the bond market. And, at least for now, the Fed seems much less willing to consider any policy reversals as it did in late 2018.
While the economy has not “broken down” given today’s rising employment, it will be hard to ignore the numerous impacts an ever-tighter Fed policy will have, especially Quantitative Tightening. Ironically, the lack of net US employment declines thus far is keeping the pressure to fight inflation alive at central banks. This is why many call for ever larger and sustained Fed tightening steps. With policy tightening rapidly, many investors are sidelined, looking for a recessionary collapse as a signal to buy, just as they could in the spring of 2020. In short, the investor’s point of view is clearly at odds with that of policymakers whose primary goal is stability – balancing inflation and employment. Once fundamentals are deeply depressed and poised to recover, future returns are usually strong, and risks are in the rear-view mirror. Distress serves up investment opportunity. Yet, it is the job of policymakers to avoid an unneeded collapse in the first place.
As Citi analysts previously wrote, credit markets are a leading indicator of financial distress in this cycle. Today, credit markets are becoming less liquid as one goes down the quality curve. Without attention to the speed of economic deceleration in the face of declining credit availability, the day may be close at hand when it will be too late for the Fed to balance its fight against inflation with sustained employment.
While risks are rising, CIO still believes recession is not inevitable. If Fed officials shift focus toward data dependence and forward-looking inflation indicators, this can be a positive sign for markets and CIO’s Resilient scenario. If a recession does occur, CIO would likely see risk assets trade lower while high quality bonds should rally. Given the binary nature of these two outcomes, the team has shifted to its most cautious – but still fully invested – portfolio stance since Q1 2020.
After this past week’s portfolio adjustments, the Global Investment Committee (GIC) is neutral on global equities (-2% excluding the hedge against high commodity prices). The Committee maintains large underweights in global SMID (small and medium sized stocks) and Europe while keeping core high-quality overweights in dividend growers, global pharmaceuticals, and cyber security. The GIC also raised quality on the fixed income side, shifting from high yield loans to preferred stock issued by higher quality investment grade firms, and remained significantly overweight US Treasuries and US IG credit.