The managers of the AIMS Target Return strategy explain why equities look to be a better option than bonds given growing expectations the US central bank has engineered a “soft landing”.
Read this article to understand:
- Why markets may be over-optimistic on rate cuts
- Why equities should do well, barring an unexpected recession
- Why investors should consider ways to hedge against inflation
After a challenging start to 2023, during which markets were impacted by macroeconomic uncertainty, vulnerabilities in the financial sector and the continuation of an aggressive rate-hiking cycle, asset prices enjoyed a strong end to the year.
Improved performance has continued into 2024, as a rapid decline in inflation fuels expectations interest rates in the US and other developed economies are set to fall over the coming months.
However, in this Q&A, Peter Fitzgerald (PF) and Ian Pizer (IP), managers of our AIMS Target Return strategy, stress a note of caution. They tell AIQ that although it looks for now as if central banks may have tamed inflation, interest rates may not fall as fast as markets appear to be expecting. That leads them to believe equities and other risk assets currently offer more value than government bonds.
While the potential for sharper-than-expected economic slowdowns remains a concern, central banks appear to have avoided deep and damaging recessions, and companies should be able to grow earnings. However, investors would be wise to stay alert to the ongoing threat of above-target inflation.
Your portfolio has recently begun to favour equities relative to bonds. Can you explain your thinking?
PF: While until recently we were long equities, credit and government bond markets, we began to take a view bond prices had moved a little too quickly. The US rates market suggests the Fed will cut four times this year; I think that would only be the case if the US economy was heading into a recession. I don’t see another scenario where the market pricing of bonds is correct, and that is good for equities. We suspect there will be fewer rate cuts than the consensus indicates, and that's why we’re happy to take some directional equity risk.
We have cut our exposure to UK rates, halved our position in South Korean rates and are still running a relatively large short rates position in Japan. So we are actually now short government bonds as a whole, while we remain broadly neutral on corporate bonds.
What are the biggest risks you see right now?
PF: The main risks for equities are twofold. One is that you enter a recession; two is that earnings disappoint. But neither is our central scenario. Having said this, equity valuations look fairly stretched, especially in the US, where the frenzy to buy shares in any company deemed likely to benefit from artificial intelligence (AI) has pushed several stocks into what I would consider bubble territory.
IP: I would add the recent rally has led to a significant easing of financial conditions. Should that cause inflation to tick up and raise doubts about the prospects for early rate cuts, equities could take that badly.
But, on the balance of probability, it looks like US inflation is going to be well behaved, the economy will avoid recession and the Fed will start easing slowly.
At that point, we will get to see whether inflation reaccelerates. But rate cuts are still some way off. The second quarter is a possibility if inflation is still under control. When the Fed says its decision is data dependent, it is telling the truth. The bank would like to be cutting, but equally won't take chances if there are signs inflation is going to be sticking at around three-to-3.5 per cent.
You seem to be particularly bullish on the US stock market. Why is this?
PF: The US economy is in comparatively healthy shape. If you are optimistic on equities, you can't really avoid having a positive bias to US equities because they now represent close to two thirds of global equity market capitalization. Nevertheless, we still have concerns about valuations in parts of the US market deemed to benefit from the growth in AI.
With that in mind, are you hedging your bets in any way?
PF: We use S&P 500 futures for our directional US equity exposure, which means we can’t avoid exposure to some of these large-cap US technology companies we have concerns about. However, we are simultaneously investing in a basket of “value” stocks. While this strategy did not do so well last year, it did very well for us in 2022 and we have retained it.
We have another position giving exposure to a selection of quality mid-cap stocks against which we are “short” of the wider US market. These value-oriented positions should give some downside protection to our US equity exposure.
There’s a lot of focus among market participants on fiscal deficits, which have been rising relentlessly. How concerned should we be?
PF: Worsening demographics, the need to tackle climate change, and the increasingly partisan nature of politics give us cause for concern over the longer term.
But if you look at a country like Japan, where debt relative to GDP is multiples of what you have in the US and euro zone, the debt has essentially been monetised by the Bank of Japan without major inflationary consequences.
If debt sustainability becomes an issue, I don't think any central bank will sit back and do nothing. While the Fed seems set to push ahead with quantitative tightening, it will just step back in again and start buying bonds at the first sign of a new crisis. Few would be brave enough to bet against some form of financial repression in that environment.
This means there may be opportunities to take advantage of rising prices of various basic resources, such as oil or gold, whether through investing in the commodities directly or via shares in firms that produce them. The rationale for this is that if central banks are simultaneously depreciating the value of fiat money, that will filter through to higher inflation.
So concern about the US deficit is unlikely to lead international investors to shun the dollar, in your view?
IP: It is unlikely the dollar’s reserve currency status will come under threat as there is nowhere else for capital to go. Most investors do not want to invest in Chinese markets, and European capital markets are tiny in comparison to the US. If you're going to move your money into other currencies you’ve got to have assets to park it in and there are limited opportunities beyond North America.
Markets were unruffled by Donald Trump's victory in 2016. Should he be re-elected in November, could we be in for a more turbulent time?
IP: I'm not sure markets are going to be paying as much attention to the US election as some commentators might wish to believe. I think the focus will be on the prospect of tax cuts under a new Republican administration.
