Investing in Volatile Times
- Central banks have been caught out by the persistence and strength of inflation and have been forced to raise rates aggressively. The failure to recognise and control inflation could lead to sustained second-order inflationary pressures and a hard landing for economies.
- The outlook for equities and bonds diverges in this environment. For equities, valuations have adjusted significantly, particularly in the eurozone, making the equity risk premium more attractive. But caution is the word for credit, from investment grade to high yield, and in both the US and Europe.
- Some private assets can deliver protection, including most infrastructure assets and some commodity-related and real estate assets. Traditional assets, if employed in smart strategies, can also be an effective hedge.
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Mabrouk Chetouane, head of global market strategy at Natixis Investment Managers Solutions believes the effects of higher prices and lower growth have flipped economics on its head. “From a world of plenty, we are now living in a world of scarcity – energy scarcity, capital scarcity, liquidity scarcity,” he says.
Natixis IM Solutions has created a scenario for how inflation and recessionary effects may play out, and what this scenario may mean for asset classes.
How we got to where we are
The persistence and strength of inflation has surprised many people – not least the world’s central banks – over the course of 2022. Consumer price indices advanced between 8% and 10% in developed countries as the Russian invasion of Ukraine drove up energy markets and consequently the energy component of price indices.
Aside from the impact of the conflict, core inflation is also strong, as a result of strong demand for services, and increases in housing rents and transport prices. In addition, the labour market has powered ahead, with unemployment rates the lowest for decades and wage demands consequently increasing. All these factors reinforce the thesis that underlying inflation will only decrease marginally throughout 2023.
Central banks were caught out, grossly underestimating the persistence of inflation. As a result, they have been forced to raise rates aggressively to preserve their main asset: their credibility.
“All central banks are aligned in signalling the raising of key rates and we see no reason for policymakers to change their stance in the near term,” says Mabrouk. “There is little to no chance of inflation rates returning to their targets even by 2023 because of the structural drivers of high inflation.”
The risks (and tail-risks) ahead
The failure to recognise and control inflation at an earlier stage could lead to sustained second-order inflationary pressures and a hard landing for economies.
Economic uncertainty is gaining ground and weighing on consumer and business confidence. The only support for economic momentum, namely domestic demand, is deteriorating and leading to a more severe economic slowdown than expected.
The risks are growing. There is now a risk of a material downturn in the housing markets of the United States and China, leading to an increase in delinquencies and a deterioration of the financial situation of households and the banking system as a whole.
Sovereign risks are also rising, particularly in peripheral European countries. This brings debt sustainability worries back into the spotlight for the first time since the 2011 financial crisis, and consequently reduces governments’ room for manoeuvre to boost economic activity. “Deterioration of economic and financial conditions in small emerging countries could lead to a chain reaction which could affect medium-sized economies,” says Mabrouk.
The tail-risk scenario of a complete disruption of gas supply in Europe has now become a likelihood, bringing a harsh winter to Europe and, potentially, political crisis in parts of the continent.
The problem with credit
The outlook for equities and bonds diverges in this environment.
For equities, valuations have adjusted significantly, particularly in the eurozone, and the equity risk premium became attractive in the middle of 2022. The price-earnings ratio, for all European markets, was below its historical average. But expected earnings growth remains in double digits for 2022 despite downgrades during the year.
Bonds are another story. The frantic monetary tightening in 2022 came hot on heels of an end to central banks buying government and, in some cases, corporate bonds.
“For the moment, we are staying away from the European bond market,” says Mabrouk. The European market has too many different stories, each with its own risks. “If we look at France, Italy, Spain and Germany, we need to consider four different downside risks and that’s just too much.”
In July, European bond market implied volatility levels exceeded those seen even during the Covid crisis. Soaring inflation, central bank pressure, recession risks, and Italian political turmoil triggered unusual interest rate movements. German government bond yields fluctuated between 180bp and 65bp and this level of volatility could remain high for many months, especially in Europe.
Conversely, the potential for further long-term rate appreciation is much more limited in the US and the level of carry is therefore attractive. “The level of US Treasuries was starting to get interesting in mid-2022, meaning we could play carry,” Mabrouk says.
Overall, however, Natixis IM Solutions believes it is wise to stay underexposed to all segments of the credit market, from investment grade to high yield, and in both the US and Europe.
Even TIPS are a poor bet in the current environment. The growth in the inflation rate has little further to run in the US, Mabrouk says. Although inflation will remain high, inflation expectations are probably fully priced into TIPS. The same is true of similar instruments in Europe.
Private assets can be a solution
The multi-asset team at Natixis IM Solutions is able to implement its views using any of the hundreds of funds managed by Natixis Investment Managers affiliates. At a time of heightened uncertainty, the private asset strategies can be particularly helpful in reducing portfolio volatility.
However, not all private assets provide a good hedge against inflation: Those that do include infrastructure, while some commodity-related and real estate strategies are well positioned too.
Vauban Infrastructure Partners, for instance, believes that the long-term nature of infrastructure with long dated, resilient and contracted cash-flows linked to inflation can mitigate the effects of rising inflation, energy price spikes, and even recession. In addition, Vauban considers that its infrastructure investors are protected from rising interest rates, as its assets are financed over the very long-term using fixed rate debt.
Renewable energy is one of the fastest-growing segments within the infrastructure market. Mirova, an energy transition specialist, sees renewable energy as a way for investors to help finance the exit from fossil fuels while protecting economies, especially in Europe, from excessive energy dependence. It’s also an effective way to diversify a portfolio in the current environment: long-term investments in tangible assets with relatively steady, low volatile, inflation-linked cash flows and low correlation to capital market cycles.
Real estate can also be correlated to inflation when there is potential to uprate rents. Although this is not always the case, AEW believes that core investments should maintain positive and attractive yield spreads compared to treasuries and that their income component should dominate capital gains in the coming years.
For private equity, as with listed equity, revenues have been shown not to have a strong link to the inflation dynamic. There is little evidence, for instance that tech companies – a staple for private equity – are connected to inflation. Having said that, some companies benefit from pricing power and manage to pass through price increases to their customers. They may be protected from their competitors by barriers to entry or provide essential products or services where price elasticity is typically higher.
Private debt is well aligned to fighting the portfolio effects of inflation, especially when loans are issued on a floating rate basis. In that space, MV Credit’s senior debt team lends to non-cyclical companies from the upper-mid market, which are robust credits with multiple products and a regional or global footprint.
Meanwhile, Ostrum Europe ABS team sees higher carry with low duration through its ABS approach.
Traditional assets with smart strategies
Traditional assets, when employed through smart strategies, can also be a successful hedge against volatility and inflation.
These include fixed-income total return strategies that benefit from a flexible toolkit rather than seeking income delivery through buy-and-hold approaches. Total return can be executed through long-short approaches, such as those employed by DNCA’s alpha bonds team or by the Loomis Sayles strategic alpha team. Both approaches also manage duration risk and are driven by global macro views.
In the listed equities space, it is not easy to prevent drawdown in the case of outright recession, but the Loomis Sayles’ value team believes that Value may be a safer place to be for investors at the moment, compared to Growth.
Other possible solutions to a volatile environment include long commodities exposure, long-short inflation strategies and liquid alternatives which can take advantage of market volatility.
Published in October 2022
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