Global supplies of consumer goods are rebounding and should help the world economy avoid contraction through a
post boom phase. Nonetheless, near-term inflation – driven by inadequate supplies – could continue to stoke fears over the outlook as the Fed tightens in a lagged reaction to inflation.
On Wednesday, February 16, 2022, our Global Investment Committee (GIC) reduced its overweight in global equities from +6% to +4%. This neutralized our equity weighting apart from specific thematic equity overweights such as Longevity (healthcare/pharmaceuticals) and Digitization (Cybersecurity software, Payments and Fintech) among other positions.
We did this largely through cuts in developed markets small- and mid-capitalization equities, preserving our holdings of large cap, high-quality dividend growth shares (i.e. our Long-Term Leaders theme.) We continue to hold a recently added overweight in China equities as policymakers reverse macro-economic tightening steps which sank local equity markets by more than 30% last year.
We raised our global fixed income weighting to -3% from -5% with another increase to intermediate-term US Treasuries and high-grade corporate bonds. With equity cuts and a reduction in the size of our variable rate loan position, the overall allocation to high-grade medium-duration securities was raised by 4%. We’ve reallocated to this fixed income sector, where we have found value, as 5-year US Treasury yields have risen 150 basis points over the last 12 months in anticipation of Fed interest rate increases.
With regards to the variable rate loan position, tight credit spreads and higher interest rates might be sustained, but they are at risk of widening as the Fed moves to both raise the cost of credit and reduce lending in the year ahead. Variable rate loans may perform solidly as short-term rates adjust upward. However, the strong performance of our loan holdings has already seen yield premiums compared to lower risk bonds compress sharply.
The correlation of loans and high yield bonds to US equities is high (63% and 76%, respectively, vs monthly returns of the S&P 500 since 2010). With macro policy risk increasing and near-term US economic growth likely to slow, we chose to gravitate fixed-income holdings back towards their traditional role as a risk buffer. Nonetheless, we still hold a loan position in place of a high-yield bond allocation, given more favorable attributes overall.
Rising energy costs, scarcity of goods will continue to trigger high inflation
The Fed is concluding a Quantitative Easing program in the coming month and suggests it will begin Quantitative Tightening steps within the year, forcing private lenders to finance a greater share of US dollar borrowing without Fed money printing. US policy interest rates are at rock bottom, and the economy can certainly withstand some monetary tightening, in line with historical cycles.
However, with both QT and a likely 50 basis point tightening step as the Fed’s first move next month (and four or more further rate hikes this year) monetary policy will turn sharply away from accommodation in a short period of time.
Rising energy costs and a scarcity of consumer goods continue to generate high US inflation, with the autos sector emblematic of supply/demand mismatches. Unlike 2021, however, consumer incomes are not being supported with government transfer payments. US federal spending fell 37% in January from a year ago and may contract even more over the full first quarter. With after-tax real incomes down, rising wages will not be sufficient to avoid a slowing US consumer.
Comments from the Fed suggest it has lost patience with a supply recovery and wants to play an active role in lowering inflation to maintain credibility. However, data suggest rebounding supplies will be the most powerful driver in stabilizing inflation now that fiscal stimulus has ended. Real US imports rose nearly 10% in 2021 and the 4Q rise in inventories was one history’s largest. A continuation of this trend should result in a marked slowing of inflation over the course of a year.
Rising production and employment seem likely to sustain economic growth across the world in 2022, albeit decelerating into 2023. A drop in US inflation would very likely stabilize investor expectations for economic growth and keep policy and market yields contained, consistent with our core, bullish investment positions. The recent roughly 10% drop in equity markets and rate-sensitive assets has already reacted to the Fed’s expected policy course. However, even gradually tighter monetary policy, risks of further supply disruptions, and the inevitable slowing in growth have altered the risk/reward calculus for equities somewhat.
Wednesday’s equity cut shifted us further underweight in volatile SMID shares, with non-US SMID the largest cut (previously neutral). Since mid-2021, we’ve allocated 10% of a balanced portfolio to global dividend growth stocks, adding further at our last GIC meeting.
These have outperformed speculative growth shares and most cyclical sectors in the year-to-date. (In US equities, our benchmarks have approximately 30% in dividend growth equities and we are now tactically overweight 3%.) With a reduction in credit exposure and a rise in high-quality yield exposure, our asset allocation is gradually moving to a more standard “barbell” of high-risk and low-risk assets. Over long periods, this has historically provided stronger risk-adjusted returns than undiversified portfolios.