The world is still lopsided – what this means for asset allocation
The three things I would tell my clients this week:
The world is unbalanced. It will likely remain so for some time
Higher yield is not “free”. It reflects rising inflation and geopolitical risks.
In this environment of uncertainty, peak (or near peak) rates and with the yield curve still inverted it makes sense that long yields (where inflation and long-term uncertainty tend to live) could remain near present levels or even rise (according to both JP Morgan and Blackrock), even as short yields fall to normalise the yield curve.
This inflation cycle is nearing its completion. In the US, core Personal Consumption Expenditure, the Fed’s favourite inflation gauge, fell below 4% for the first time since June 2021. If this Friday’s employment data are weak, it is possible that the Fed could focus on impending economic weakness and put an end to rate hikes altogether. As the world loses the benefit of an H1 Chinese resurgence, the economy is slowing down. And while a “soft landing” is the base case scenario for many investment firms, the level of confidence is low.
For all their proclamations of a soft landing, after all, policymakers know that predicting a recession, let alone its depth is a fool’s errand. Since 1995, there have been six separate occasions at which “Soft Landing” became a keyword. In two of these cases (2000, 2007) the landing proved pretty hard. In two others, 1995 and 2011, the economy didn’t land at all. The IMF has famously failed to predict any global recession. In October 2007, San Francisco Fed Chairman Janet Yellen famously said “the most likely outcome is that the economy will move toward a soft landing”. This wasn’t a bad prediction, with what was known at the time, which is why no one held it against her. She went on to become the first woman to ever lead the Fed or the US Treasury.
The x-factor, however, is not the trajectory of the economy. Rather, it is persistent geopolitical instability. All forecasts assume a “ceteris paribus” basis, Latin for “all other things being equal”. Only things haven’t been equal for some time. The geopolitical instability which started with China’s great leap forward away from being the world’s manufacturing hub, continued with the trade wars that started in 2017. The pandemic further widened geopolitical rifts. The war between Russia and Ukraine forced the world to take sides, officially ending decades of post-Soviet cooperation.
As oil prices continue to hover near $90, investors are worried whether a new cycle of inflation will play out, mirroring the 1970’s-style up-and-down inflation, the kind that takes a double digit interest rate to break. And while a rumoured deal between the US, Saudi Arabia and Israel could potentially ease oil pressures for now, it is worth understanding that it takes years to stabilise an unbalanced world.
History teaches us as much.
The week marks the 50th anniversary of the Yom Kippur War. The fourth Arab-Israeli conflict was fought between 6 and 25 October 1973. Before the war was over, King Faisal of Saudi Arabia, angered at US aid to Israel which helped tip the war, declared an oil embargo on the United States, a move which led to the 1973-1974 Oil Crisis. During that time, the price of oil quadrupled, from $3 per barrel to $12 per barrel.
The embargo itself lasted five months, and eventually, things calmed down. With all sides realising that they did not have the strength to fight indefinitely after four armed conflicts, Egypt and Israel eventually found themselves on the negotiating table, under the auspices of the US, signing the Camp David Accords in 1978 (a masterclass in Negotiation by the way). Yet that wasn’t the end of it. Two of the three main characters involved in the Camp David deal were murdered. Egyptian President Anwar Sadat was killed in 1981. Yitzhak Rabin, the first Israeli PM to initiate peace talks (ultimately the accord was signed by Menachim Begin) was assassinated in 1995. The blame on America for helping Israel in 1973 simmered leading to the uprising in Iran and the Second Oil Crisis in 1979. In turn, this led to the Iraq-Iran war in the early 1980s, with consequences as far as 1991. It can be argued that the instability spilt over all the way into 2001. Meanwhile, the global economy suffered from low growth and high inflation, which led to record-high interest rates in the 1970s.
A war of no more than three weeks led to consequence after consequence.
The war between Russia and Ukraine is already much bigger than Yom Kippur. Lasting for over a year and a half, it has forced actors all across the globe to take sides. One of the countries directly involved owns the world’s biggest nuclear arsenal, as well as the world’s largest gas reserves. The other is a key food producer. The war has divided legislatures in the West, and it would not be a surprise if support for Ukraine became a theme as we enter the 2024 US Presidential Electoral cycle.
And it comes at the heals of seven years of prior geopolitical destabilisation.
Markets, who hate instability, are finally realising that the era of geopolitical convergence is over, and in that respect, the world now resembles the 1970s. While it will probably not be as bad (the 1970s also featured a departure from the Gold Standard), the inflation and growth backdrop is much more uncertain than before the pandemic.
Markets, used to 14 years of risk and yield suppression, hate instability and surprises, even in Developed Markets. Liz Truss, the UK’s shortest-tenured PM in history learned that lesson well. And because they don’t have experience with geopolitical risk, they are probably not very good at pricing it. A quick chat with investment teams in the City will show how wide inflation and growth expectations are, even within teams. The “House View” is nearly impossible to produce without dismissing one view from the fold.
What does this mean for investors?
One word: opportunity. The bane of investment portfolios during the QE-era was none other than consensus between investment strategists and central banks. How can one produce Alpha if everyone agrees on what the future holds and eventually that’s how it plays out.
In our recent Investment Committee, we decided to remain underweight duration, bucking the market trend of buying long bonds in anticipation of lower rates. In this environment of uncertainty, peak (or near peak) rates and with the yield curve still inverted it makes sense that long yields (where inflation and long-term uncertainty tend to live) could remain near present levels or even rise (according to both JP Morgan and Blackrock), even as short yields fall to normalise the yield curve. Our equity allocation remained close to the benchmark, meanwhile, reflecting the economic uncertainty and how it will play out in earnings, especially in the tech sector where valuations seem to be somewhat optimistic if one considers recent earnings trends.