The managers of the AIMS Target Return strategy explain why the prospects for a range of asset classes suddenly look much brighter.
Read this article to understand:
- How signs inflation has peaked are driving asset allocation
- Why bond markets are suddenly starting to look attractive
- Why peak rates and better economic prospects should underpin risk assets
Interest rates look to be close to peaking across the developed world, even if leading central banks are unlikely to be able to declare victory in their battle to tame inflation for a while yet. Meanwhile, leading economies have fared better than seemed likely six months ago.
Against this backdrop, Peter Fitzgerald (PF) and Ian Pizer (IP), managers of our AIMS Target Return strategy, tell us what this means for risk assets and portfolio positioning.
The governor of the Bank of England (BoE) recently said interest rates may have peaked. Do you agree?
IP: The BoE may have done enough but it can't risk losing credibility at this point, so I wouldn’t expect it to flip to cutting rates in a hurry. The bank has had to raise rates further than it might have needed to because it was too cautious initially. When inflation surprised to the upside, it had no choice but to respond. But, as a result, there now looks to be little chance of avoiding a recession.
Economic growth is weak, unemployment is picking up and house prices are falling. Moreover, we know mortgage holders who took out two-year fixed rate deals in late 2021 and early 2022 are going to have to contend with some brutal increases in interest payments over the next three to six months.
It isn’t just mortgage holders who are going to be affected. Although as many people own their homes outright as have mortgages, once you start to get house prices falling, people’s sense of wealth gets impacted.
What about rate expectations in the US and Europe?
IP: It appears most of the impact of US monetary tightening has fed through. We’re more optimistic the US can avoid a recession, although it is still 50:50 there is a "soft landing" or slowdown. Recent inflation figures have been encouraging, without much damage to the labour market. The unemployment rate has ticked up slightly but the job participation rate also picked up so I think you can look through that.
The labour market looks to be softening, but mainly on the vacancy side, and employment is still high. The Federal Reserve will be especially pleased wage pressures seem to be abating quicker than might have been expected.
It is possible the Fed will cut rates next year, but they will be small, tentative cuts and the first sign of growth in labour market demand will halt that process.
As for Europe, it is unclear how much of the slowdown has been due to rate rises. The region is being impacted more by slowing global growth, particularly in China, and last year’s surge in commodity prices, which continues to weigh on household incomes.
When we last spoke, you thought rates markets were too optimistic in terms of pricing in rate cuts.1 Is this still the case?
PF: Those markets pricing several cuts over the next 12 months are probably getting ahead of themselves; there's still a reasonable chance the Fed and other central banks do nothing. In any case, we see rates staying at levels that were more common before the Global Financial Crisis than after it.
There seems to be a false hope among some that rates can go back down to zero or one per cent. That's emergency territory. We don’t see US rates falling below 2.5 per cent, potentially higher.
IP: The front-end of the US yield curve looks expensive given our expectations for the economy, but not crazily so. If there is to be a cumulative rate move of 150 basis points next year, you would think it would be cuts, not hikes. Further along the curve, US bonds are starting to look more reasonably priced. Ten-year Treasuries, for instance, appear to be pricing in a "neutral" rate of interest of between 4.25 and 4 per cent. That suggests if you were to buy Treasuries on a medium-term basis, you would do ok. The big risk is if a term premium were to return. This has been talked about for the last decade, so I'm sceptical it will happen, but it is moderating our appetite for long duration even as we move in that direction.
How is this environment influencing your thinking around portfolio positioning?
PF: The key change has been a pivot effectively from having quite a large short-duration bias across the portfolio, to now being modestly long duration. The only market where we are still short is Japan, but idiosyncratic factors explain that. If you take Japan out, we’ve got reasonably long-duration positions of around 3.5 years. The largest position from a risk perspective is receiving short-term UK rates. This is driven by our belief inflation has turned a corner and is on its way down with less pain than expected.
IP: Given the improving inflation outlook, it makes sense to assume rates are close to peaking. If you buy into a market where yields are above policy rates, which are in turn close to peaking, historically that has proven to be the right thing to do.
We are looking at markets such as South Korea, where the yield curve is still positively sloped. And we’ve also been looking at the short end of the UK, which had begun to price in too much tightening. We do not expect to see rates back to zero, but expect the next big move to be down rather than up.
Is there a risk soaring fiscal deficits eventually begin to damage investor sentiment?
IP: There may come a point when it does, but in most developed markets it still appears a long way off. The US was recently downgraded by Fitch, but the market took it in its stride. The dollar will continue to be in demand – talk of its demise is overdone.
PF: A simplistic view is if you consider the size of budget deficits, nominal GDP growth is still larger. This basically means debt-to-GDP is not growing, even as budget deficits are still pronounced. Effectively, we are seeing policies being implemented that many people thought should have happened prior to COVID to try to get out of this low-growth world.
Riskier asset classes have been in demand. Do you expect the rally to continue given the favourable rate environment and improved economic backdrop?
IP: Relative to earlier in the year, we have got a bigger weighting to equities and credit, including high yield. Hopes the US is heading for a soft landing mean we see more potential for risk assets to do well over the next three to six months. Within equities, we have a broad bias towards value but it’s not a large position.
PF: US equities, which account for 60 per cent of global market capitalisation, are on the expensive side and could hint at disappointing returns. But that doesn't mean they won't be positive, just less than the long-term average.
The one equity region where we have a zero weight is emerging markets. Even though emerging markets can offer good growth, this doesn't necessarily translate into shareholder returns. China accounts for 40 per cent of the emerging market index, and it has an increasingly poor corporate governance record.
Moreover, we have got a negative view of China over the next ten years from an economic and geopolitical perspective. We are not expecting China to suddenly implode, but declining GDP growth, high debt, an unbalanced economy and an ageing population are all legitimate sources of concern.
Many of the things we saw happen to Japan in the late 1980s and early 1990s are now happening in China, just on a much larger scale.
IP: If you look at problems in the property market, for example, policymakers seem to accept there is a limited amount they can do. They are trying to manage the fallout from it but are intervening far less aggressively than developed countries might be expected to. The policy of the government isn't to worry about shareholder returns when determining the best course of action. It is hard to really know what the roadmap looks like other than it is bumpy and uncertain.
There were some concerns about risks to financial stability earlier in the year. Have these worries evaporated?
IP: Parts of the commercial real estate sector are still challenged; as for US banks, loan growth is still being impacted and regional banks’ cost of borrowing is still elevated relative to where it was a year ago. But I don't see risks that could take down the whole system. The Fed would step in to prevent a repeat of the financial crisis.
