Cross Asset Strategy
We’re now a couple of weeks into Q2 and it’s clear that markets are still struggling to digest the combination of uncertainty from Ukraine, high global inflation, inverted yield curves, and growth downgrades. Most asset classes have started the quarter down, whether in global equities, DM and EM sovereigns, or IG and HY credit. Commodities have once again been the bright spot, though with considerable volatility.
Downside factors to global growth momentum are starting to mount, as evidenced by the highly publicized IMF downgrade to the global growth outlook. In China, increasingly widespread lockdowns have put renewed pressure on activity data and could also put additional strains on already stressed global supply chains. This is on top of the flurry of downside factors that were already relevant, and both earnings and top-down growth forecasts are at risk.
While markets have been under pressure, all things considered, risk assets have held up fairly well. The largest moves for the past week have been reserved for developed market rates, and particularly US Treasuries. It’s difficult to understand why, but it seems that the market focus has been on the supply side – supply chains, supply-driven inflation, stagflation concerns – with little concern that demand will take a hit. Recent data, however, point to more evidence of demand being affected in the next two quarters, potentially leaving risk assets more exposed in the coming months. As a result, we have turned more cautious in line with our “late cycle” view. As you’ll read below, we are turning more positive on fixed income and more cautious in equities.
Strategy Question: How have markets historically performed during late cycle periods?
In the Asia Strategy Weekly published two weeks ago we discussed how fast this cycle has progressed and our view that the economy will be late-cycle by the second half of 2022. We came up with two broad conclusions: core fixed income is becoming more attractive; and return expectations for equities will likely soften. Today we delve deeper into each asset class and explore how to invest within this backdrop.
1. Fixed income
Extend duration. Late cycle is set-up time for potentially rocky roads ahead. While the yield curve tends to be flat, extending duration provides more diversification value in a downturn. Table 1 below provides a simple example of how longer duration Treasuries would perform if yields were to decline (as we would expect in a recession). Also, as shown in Table 2, historical returns suggest that higher quality assets tend to outperform late-cycle because they have less sensitivity to spread-widening and higher sensitivity to declining risk free rates. That means investors may consider building allocations to core fixed income.
Move up in quality. Credit fundamentals tend to fluctuate throughout an expansion, with early-cycle deleveraging giving way to less creditor-friendly behaviors as the cycle matures. The damage is realized as revenue growth slows and margins compress heading into a downturn. Early in the credit cycle is the time to take risk and look for extended credit opportunities. Late-cycle is a time to dial down risk.
Prepare for mean reversion in the yield curve and credit spreads. The yield curve typically flattens during expansions as the central bank raises its policy rate towards neutral. Yield curves can invert in late-cycle when the policy rate is at an elevated level, economic activity deteriorates and markets expect policy rates, in response, to decline in the future. Outside of the 1970s, yield curve inversions have been fleeting, as they are typically followed by the Fed eventually cutting rates due to either a recession or after generating an intended soft landing. Like the yield curve, corporate credit spreads oscillate around their mean throughout the business cycle. Spreads tend to widen dramatically in the lead up to and during recessions, before tightening rapidly as downturns flow into early-cycle. Since 1994, HY option-adjusted spread (OAS) has only been above 700bps for 15% of weekly observations. Periods with OAS above 700bps are on average followed by 18% 1Y returns, versus 6% for periods below 700bps. Clearly this would be a good level to buy.
How to implement? We favor IG bonds; use derivatives to capture curve mean reversion rates; and put HY on your radar if credit spreads significantly widen from here. In the private space, core real estate/infrastructure are good illiquid core duration proxies; use distressed credit strategies to capitalize on market dislocations.
2. Equities
Move up in quality. For us, “quality” means the following three things:
- High gross margins/profitability indicate that the company has strong pricing power, and is able to maintain earnings growth in the face of rising expenses. Large cap firms with pricing power have historically outperformed small caps in late cycle. Sectors to consider: Healthcare, Utilities and Software.
- Defensive revenue streams that can weather an economic deceleration. Companies with stable earnings will continue to pay out, if not grow, dividends. Sectors to consider: Healthcare, Staples, Utilities.
- Secular demand drivers where revenues are unaffected by higher rates. Growth, where secular ideas generally live, has historically outperformed cyclicals late cycle. Sectors to consider: Healthcare and Technology (sectors we like in both public and private markets).
3. Volatility
Volatility refers to the measure of how much an asset’s price and returns move (relative to the average) for a given period of time. Volatility is usually driven by the level of uncertainty of an asset’s future cash flows, price, and value – and commonly used as a measure of risk. Historically, volatility varies considerably across different stages of the business cycle: highest during a recession (due to uncertainty around the future of the economy) and lowest in mid-cycle when economic momentum is strong. Late cycle, volatility generally inches higher as economic clarity wanes, alongside slowing growth and restrictive monetary policy.
How to implement? Derivatives could work for investors looking to either hedge or protect their portfolios or profit from a particular view. Volatility is one of the most important variables in pricing structured notes and option strategies, where higher volume generally means more favorable terms for investors. Investors may consider option strategies as a replacement for cash equity exposure or as a way to stay long-risk with protection on the downside. Investors may also take advantage of the higher volatility environment through systematic overlays (e.g. SPX put writing) as well as Structured Notes, which typically sell volatility.
4. FX and Commodities
Historically, late cycle is a mixed bag for the dollar. After broad-based strength in mid-cycle, the dollar tends to rally against developed-market currencies and depreciate against emerging market currencies in late cycle. We suspect the key driver of the divergence is inflation fighting credibility; in a relative sense, emerging-market central banks lack credibility and need to hike rates more than developed-market central banks to keep/lure investment capital. That said, with recession risks elevated, we also wouldn’t bet against the dollar.
Late cycle produces great absolute returns for commodities. One could argue late cycle is the only phase of the business cycle where one should cyclically own commodities. Gold for its defensive characteristics and oil for its cyclical demand-led surge. Oil has the added benefit of supply restraints this cycle. The COVID demand surge for oil has highlighted that many economies have over-invested in renewables for the future and underinvested in fossil fuels for today. This supply and demand imbalance is likely to last beyond this cycle and makes us optimistic on commodities over the medium term. Higher fossil fuel costs will likely translate to higher revenues, profits, cash flow, and dividends for producers, at a time when other companies see margin deterioration as their input costs accelerate.
How to implement? We are fine staying long USD. Within commodities, we favor adding exposure in either the cash equities or derivatives space. Investors may also consider exposure to gold for the diversification benefits.
All market and economic data as of April 21, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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