Over the past few months, our models have ditched equities, pushing allocation to levels close to or even below zero. The main reason for this is the hawkish turn in central bank policies against inflation which has put an end to easy money and high-flying growth expectations in the market.
Now the question is, when do we go back to the market and why?
As things stand today, markets paint a rather bleak picture for equities. Liquidity is still at decent levels, even if it is being gradually reduced, giving central banks further room to continue tightening the screws. The same goes for the economic outlook which may have darkened but still sends some positive signals.
This is worrisome to investors who may have priced in more front-loaded rate hikes for this year but who fear that central banks could overshoot their targets and thwart growth, plunging the world into a full-fledged recession.
Refinancing conditions for corporates have worsened over the past few months which is not only reflected in rising credit spreads but also in the money big lenders have started to set aside to prepare for the higher likelihood of defaults.
Also, falling equity prices do not yet warrant a re-engagement with the market based on more attractive valuations if rampant inflation continues to stir up central bank activism. To sum up, now is not the time to take risks.
Back to the basics
There aren’t many instances in the past when a traditional balanced portfolio returned negatively in two consecutive quarters due to bonds and equities falling in tandem: only the 70s and the early 90s serve as examples.
Back then, like today, inflation reared its ugly head and central banks took centre stage. So, there isn’t much to go on when it comes to fathoming what’s going to happen next and which route investors should take.
If history does not offer much guidance, the good old dividend discount model does. According to this, either interest rates (as part of the discount factor) must fall, or growth has to rise for equities to re-embark on an upward trend. Which one of these two will happen, and if they will happen at all any time soon, will be decided by the main game changer – inflation.
In either case, equities are in hot water. If growth continues to be strong and inflation does not let up, central banks will keep on hiking rates. This is bad news for equities.
If growth weakens, or even falls, central banks will back off. However, this is bad news for equities too, as weak economic growth is not conducive to attractive equity performance.
Basically, we need central banks to make a 180-degree turn and adopt more accommodative policies for equities to be able to restore their lustre. This is unlikely to happen until inflation has firmly been put back in its place for a while. In fact, currently, it looks like neither inflation nor interest rate hike expectations will abate before 2023/2024.
Our models will start re-building their equity positions when a combination of the following macro and micro factors and the investor sentiment towards their development warrants a re-engagement with the market: economic growth outlook, liquidity conditions, valuation levels and refinancing conditions for corporates.
The future trajectory of these variables heavily depends on the current drama’s main protagonists: central banks. Most likely, the economic growth outlook, represented by the term spread, will set the tone in markets and as well as our models.
Recently, this indicator has started to send some hesitant positive signals prompting our models to slightly reduce their equity underweight. However, it is much too early to return to a full risk-on positioning.
As usual, equity markets are likely going to try to anticipate the central bank turnaround with some volatility along the way. Already now, they seem to be grasping for any positive news that the market is offering, such as indicative survey results on inflation and anecdotal evidence on positive earnings reporting.
This behaviour could trigger flare ups of small bear market rallies here and there. As result, markets are likely to remain choppy for some time to come requiring a sober look on market signals and a defensive positioning calibrated with systematic rigor free of common behavioural biases.
Daniel Seiler is head of the Vontobel Vescore team. The views expressed above should not be taken as investment advice.