The danger to investors of idealising the past.
Uncertainty is making a comeback in the markets, and this requires a change of approach to asset allocation.
While the last week or so has seen a surfeit of central bank meetings, the trend in activity with respect to monetary policy has been towards sticking rather than twisting in terms of rate hikes. While the ECB raised its policy rate to 4%, the Bank of England, the Swiss National Bank and the Federal Reserve all kept rates unchanged. The Bank of Japan again did nothing in terms of raising its policy rate from -0.10%.
There is a sense that the furious rate hiking cycle is either over or nearly over. While central bankers are still talking tough, it is now for the markets to decide whether enough has been done in terms of finishing the job of killing-off inflation.
We haven’t seen a policy-tightening cycle this fast or this aggressive before, especially following a starting point of zero or near-zero interest rates for the best part of 15 years. Given rate hikes ‘work’ with at 12 to 18 month lag, one question is whether central banks have over-tightened.
In the US, a number of recession indicators have been flashing for what seems an improbable length of time. The spread between the US 2yr and 10yr yield curves has been inverted (negative) since July last year. The Confidence Board leading indicators index (see graph below) has been negative for about the same length of time. M2 money supply, as well as other more precise monetary measures such as ODL (other deposits and liabilities) have been falling. ISM new orders have fallen for five successive quarters.
While these aren’t market timing tools, collectively they have usually indicated a subsequent tightening of bank credit, a necessary precursor to a recession. With US bankruptcies nearing 2008 levels, and with credit card and auto loan defaults on the rise, both companies and households are starting to feel the pinch. Distress in the US commercial real estate (CRE) sector is only the most obvious part of this trend.
On the other hand, there is the question of whether central banks have done enough to kill inflation. If one looks at the Eurozone, German 2yr bonds yield just 3.25% at the time of writing. While Eurozone inflation is down from 10.6% in October 2022, it is still at 5.2% as of August 2023. The ECB policy rate is only 4%. The lesson from the 1970s was one of central banks declaring victory over inflation only to see it come surging back in successive waves. With oil prices again on the rise (Brent Crude is currently at $92 from a summer low of just over $70), headline inflation may prove sticky.
But headline inflation (which includes food and energy) is not the measure central banks focus on. They tend to look at core inflation, and within that wage inflation. In the UK, August year-on-year wage inflation was 8.2% even with unemployment rising to 4.3% from 3.8% in July. Rising wages and rising unemployment is the ultimate stagflationary red flag. US wage growth was also strong in August at 5.3% while unemployment was still sub 4%. Rising wages and tight employment are not part of a narrative in which inflation has been whipped.
This leaves investors in a very sticky position - either inflation will rebound, or the central banks have overtightened, raising the chances of a dislocation in the credit or bond markets which could in turn deepen a coming recession. For most of the year, the US equity market has apparently been pricing in a soft- or no-landing outcome, but equities have suddenly started to look choppy, including the ‘magnificent seven’ tech stocks which have led the charge in 2023. Uncertainty seems to be making a comeback.
Socialists in the nineteenth century may well have drawn on Sir Thomas More’s 1517 work ‘Utopia’ as a model for a non-market economy. While it is unclear whether the book provided an inspiration to Karl Marx’s enigmatic pronouncement ‘From each according to his ability, to each according to his needs’, much of More’s Utopian model chimes closely with Marx’s thinking.
In More’s ideal, there would be no commerce or money, although everyone would have to work (an early mention of the labour theory of value). There would however be plenty, and households would take what they needed from a common store of goods. Families would swap houses every decade to dissuade them from becoming overly attached to property. Chamber pots would be made of gold and silver to disavow people of a love of money, while children would be given jewels as toys so they would learn to outgrow them as they moved into adulthood. While Soviet Gosplan central planning didn’t focus on golden toilets, the similarities are clear.
Yet to understand More it is necessary to realise he was reacting to the deep social and economic changes Europe was undergoing at the beginning of the sixteenth century. The New World had just been discovered, and bullion and other commodities were starting to flow back to Spain, Portugal and elsewhere. Banking had sprung up in Italy, and the lending of money for interest was already undermining the Catholic church’s laws against usury (the lending of money for interest). For More, commerce and change were the enemy of godliness.
More was essentially a reactionary, albeit a well-meaning one. The Utopian vision he had was one where he harked back to the high middle ages and the essentially static society it represented. He was fighting a losing battle. In the same year as More wrote Utopia, Martin Luther published his 95 theses, and while Luther’s focus was solely on the individual’s relationship with god, the implications of this new protestant individualism arguably played a key psychological, economic and philosophical role in Europe’s radical development in the coming centuries.
Why should investors care about an aside into sixteenth century humanism and the economic views of a catholic martyr which proved not only to be wrong but whose intellectual inheritance arguably foreshadowed communism and all its ills? More’s problem was that he wanted the future to be like the past, and many investors seem to be acting in just the same way. For most of the last 40 years, the 60/40 portfolio of equities and bonds has served investors and asset allocators terribly well. Why change now?
The main reason for the success of the 60/40 portfolio is that bonds and equities were negatively correlated - one goes up while the other goes down. As inflation fell from the 1990s onwards, equities rallied. When recession loomed and equities fell, central banks cut rates, meaning bonds made enough money to offset the equity losses. Everyone’s a winner. Well yes, until you get to zero rates and then inflation emerges. 2022 saw rising inflation and rising interest rates, and bonds and equities were smoked. Bonds have been hit again in 2022, and should there be a recession, corporate earnings will likely fall, meaning equities will trade down. If bond/equity correlation stays positive, it’s no bueno for the 60/40 portfolio.
Like Thomas More and his desire to keep the world as it once was, investors who stick to the 60/40 portfolio and particularly those who look at past equity winners as bets on the future may become unstuck in a changing world. A different approach is clearly needed if the future is one of higher inflation, higher rates, higher volatility and potentially other secular changes like the energy transition and the rise of geopolitical multipolarity.
Some investors are adapting. Readers of the UK’s Sunday Times money supplement will have noticed that yesterday, the in-house stock picker Ian Cowie was singing the praises of Yellow Cake (ticker YCA.LN), a uranium trust security1. Last year, Cowie mentioned that he had added to his holdings of the gold miner Newmont (ticker NEM) as a hedge against inflation and poor bond market performance2. Commodities have been the investment leper relative to the success of bonds and equities for much of the last decade and a half, but Mr Cowie seems to think that might be changing.
Mr Cowie clearly has a diversified portfolio, much of which is still invested in what might be termed more conventional equities, but it is notable how savvy long-term investors are diversifying their holdings into other asset classes such as commodities given the degree of uncertainty about what the future holds for past winners in the bond and equity markets. In terms of asset allocation, More’s the pity for those who don’t abandon the utopian view that the investment future will always be just like the past.
If you enjoyed this post, please subscribe below for the next instalment to be sent direct to you inbox - so cheap it’s free!
Ian Cowie, Yellow Cake looks a reliable energy investment. I’ve helped myself to a slice, Sunday Times 24/09/2023.
Ian Cowie, My inflation-proof investment in gold has plunged. So I’ve just bought more, Sunday Times, 04/09/2022.