Q3 Multi asset perspectives: Storm before the calm

GAM Investments’ Julian Howard outlines his latest views, exploring how the nightmarish policy trade-offs governments and central banks face today won’t last forever as inflation slowly but surely eases in the coming months.

10 October 2022

Review

Global equities, as measured by the MSCI AC World Index, declined in the third quarter of 2022, falling -4.0% in local currency terms. But this masked an even more volatile journey, with a benign summer period in which the market regained its poise from earlier volatility giving way to fresh panic about inflation and interest rates. Perhaps the more telling picture could be gleaned from the action in the 10-year US Treasury yield, which rose from 3.0% to 3.7% over the review period. The inflation and rates story continued to dominate markets for the simple reason that efficient asset price discovery cannot happen without certainty about the likely trajectory of the cost of capital. The ‘everything sell-off’ which has characterised both the year to date as well as the third quarter, is at its heart a reflection of the ongoing difficulty in determining a price for any asset at all, from stocks and bonds to gold and bitcoin.

Core US inflation disappointed markets by coming in at an elevated 6.3% for August, thus postponing any immediate prospect of easing by the US central bank. Compounding the situation, US Federal Reserve (Fed) governor Jay Powell remarked at the annual Jackson Hole symposium that “We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to two percent.” The Fed’s monetary policy committee went on to raise rates by fully 75 bps in September, sending US equities down, especially rate-sensitive technology stocks.

In the UK, the mini-budget of the new Truss government highlighted the near-impossible policy trade-offs of the current global economic backdrop: a slew of pro-growth policies were greeted by sharp sterling depreciation and a spike in gilt yields as markets appeared to balk at the prospect of unfunded stimulus which may not even work given both the Bank of England’s attempts to deal with inflation and the exceptionally tight labour market. The UK central bank eventually intervened to restore calm but global markets’ price action over the quarter increasingly reflected pessimism that a high inflation, low growth outcome could be avoided at all.

Chart 1: Coming soon to an economy near you? UK markets see only bad choices

Chart 2: Equity earnings yield still ahead of long term risk-free rate:

Outlook

The well-worn expression, ‘It’s always darkest before dawn’ seems especially prescient at this juncture. The issue is whether it is 5am or still 2am. Developed equity and bond markets face a perfect storm of high inflation, tight labour markets and a slowing economy. Even for policymakers with the right intentions, independent central banks ramping up interest rates regardless of their effect on growth represent a very real negation risk. This danger exists not just in the UK but in many economies, the awkward policy challenge being of stimulus undone by tighter monetary policy because co-ordination between policy-setting bodies would somehow be seen as collusion. However, we believe that relief is on its way from another source and that the cornerstones of long term investment remain unaltered by the recent turmoil.

On said relief, there are now palpable signs of naturally easing inflation. In the US, headline CPI has started to slow its ascent. Oil and commodity prices are easing off as supply chains adapt to the war in Ukraine. Similarly, there is now evidence of wage hikes cooling amid rising labour market participation in many advanced economies, particularly by more senior cohorts. It should also be noted that for all the determination apparently on show by the Fed, the monetary policy response to this round of inflation has been relatively muted when compared with previous instances such as in the early 1980s under chair Volcker. The Fed appears to be looking for an off-ramp and we believe that a cooling in inflation would be well received and, if proved durable, should result in a less aggressive policy tightening path.

For long term investors of course none of this should matter too much, though we accept that the current turbulence is unedifying and self-doubt is only natural on the more extreme days. It is worth remembering that the Siegel Constant of 6.5-7% is the real return net of dividends generated by equities over a period of many decades and so remains the fundamental tenet of portfolio construction. That stated real return over time already includes the wars, inflation spikes, and policy errors of the past. many of which were far more extreme than we are seeing this year. This alone should provide justified confidence to investors that markets have seen all of this before and should recover, just as before. The real shock may be how soon this recovery begins to occur.