Chris Leyland, True Potential Director Of Investment Strategy, looks back on the key themes around the True Potential Portfolios over the past month.
As part of our commitment to transparency, we always share the rationale behind the decisions we make when managing the True Potential Portfolios.
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July has been a positive month for both equities and fixed income. This has translated into all ten True Potential Portfolios providing positive returns over the month.
We believe the optimal way to be positioned in the near term is prudently due to the following factors;
- Inflation in the US, UK and Europe is elevated and proving to be sticky.
- Central banks are responding by accelerating monetary policy tightening to cool demand.
- They are doing so at a point of slowing economic growth, which presents a challenge.
However, our prudent approach also recognises a number of key influential factors, namely;
- A deep rooted recession is not our base case i.e widespread declines in economic activity.
- A key point is the strength of labour markets supporting demand and corporate profits.
- Corporate balance sheets are in a reasonable position.
- Equity and bond prices have moved significantly this year.
Context
Inflation.
Headline inflation in the US is still pushing higher, latest readings for June +1.3% MoM with a 9.1% increase over the year which was 0.5% ahead of last month and 0.3% ahead of expectations.
The breadth of inflation is now manifest in the stickier components of the index. For example, inflation is rising even though some of the more cyclical components are moderating e.g. used car and freight prices. Whilst annual Core inflation was lower on the month the moderation was less than expected at 5.9% from 6.0%. The Fed’s preferred method of measuring inflation, Core PCE, is currently running at 4.7% – more than 2x target.
We are seeing a similar theme across the UK and Europe, a situation intensified by higher energy prices with energy supply issues particularly prevalent to Europe given the Bloc’s reliance on Russian gas.
In Japan headline inflation has moved 50bps above their 2.0% target, a data point we are watching carefully to assess changes to the BoJ’s policy of yield curve control programme.
The True Potential Portfolio View.
- Inflation in developed and select emerging markets will be stickier and harder to moderate. A moderation will come through a combination of base effects, improving supply conditions and demand cooling as a result of Central bank action.
- We anticipate US inflation to peak in Q3 2022 and moderate into next year. That peak is potentially Q4 2022 or Q1 2023 for the UK and Europe.
- Until we have more evidence that inflation is declining meaningfully, we anticipate further monetary policy tightening.
Economic growth is moderating.
Economic growth forecasts have deteriorated over the month.
With faster tightening, the True Potential Portfolio view is that growth in the US will land just below the long term average for 2022 and is expected to soften further through 2023. We don’t believe we are at a cliff-edge as growth remains well supported by corporate and household balance sheets. An effective desire to spend / invest is supported by robust labour markets.
The evidence of slowing economic growth is stoking market concerns of recession. At this point whilst near term focus is on monetary tightening, market expectations are for the Fed to start reducing rates through 2023.
Recession risks are rising.
A technical recession is defined as: “Two consecutive quarters of negative growth in real GDP”. However, the National Bureau of Economic Research (NBER) defines a recession as: “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”
The True Potential Portfolio View.
At the beginning of the year recession was not our base case, however, we acknowledge probability has increased. At this stage the Fed does not have this as their base case hence scope to continue tightening policy. For us, key factors why we do not envisage a severe recession are the strength of labour markets and the resilience of corporate balance sheets.
Earnings at risk of negative revision.
Reported corporate earnings have so far been robust. As at July 29th, 56% of S&P 500 companies had reported for the Q2 earnings season. 73% have produced earnings above analysts’ estimates and 66% have produced revenue figures above analysts’ estimates. A lot of growth is from energy and materials and as the base effect rises they look vulnerable to revisions due to recent falls in commodity prices relative to a year ago. There have also been headwinds from a stronger USD for those companies with USD as a reporting currency. Forward guidance in the current earnings season will be important in the sense that we will get a sense of corporate confidence to hire and invest for future growth.
Opportunities are being identified within fixed income.
Higher yields in sovereign bond markets are now offering more compensation for the risks being faced.
Our sub managers have continued to look for ways to increase duration primarily in the US and UK, but not significantly given the risk of inflation surprising to the upside and further tightening by Central banks. They are targeting the longer end of the sovereign curve as a hedge against a negative economic surprise.
Wider spreads in credit markets are being scrutinised. The challenge, spreads are widening for a reason, economic growth concerns. Whilst more attractive, there is not a consensus amongst our managers that spreads fully compensate for the risk. There are nuances with stock pickers and income managers identifying selective opportunities within single names that they believe fully discount such risks. The challenge is higher spreads, and therefore higher yields are making primary debt issuance expensive thus supply is limited. For context in the US a typical year would see $450bn of primary issuance, this year markets are tracking for $140bn. In European high yield markets, the next issuance is not expected until September.
Style.
Year to date, the call to have a tilt to value has been correct. As at the end of July, value focussed global equities have declinned-8% year-to-date compared to -20.5% for growth. Given our base case, we maintain a preference for value over growth companies. However, high quality, strong cashflow business models are preferred over cyclicals.
Alternatives.
Remain an important component of our portfolios. Absolute return strategies are useful providing diversification in an environment which has the potential to continue to challenge traditional diversifiers. Real assets including infrastructure help provide a degree of inflation protection as a result of contract structures.
Positioning.
Timing a recession and gauging its’ depth and duration are challenging. At this point we recognise the probabilities of recession are rising. For this reason, coupled with the impact of higher inflation we have been repositioning portfolios in a few ways.
Since the start of the year, equity weightings have been reduced; the main reductions taking place in US and Europe. Fixed income allocations are higher, particularly towards sovereigns, with higher yields on offer attractive in this environment. Alternative weightings have increased as we continue to look for differentiated sources of risk and return premia.
Over the month, the above trends have continued with the main change being further additions to sovereign bonds.
Conclusion.
- A key development has been the markets shift in focus. Previously on inflation, it is now firmly focused on the growth outlook.
- Yield inversion in the US sovereign bond markets along with other softer economic data points and weaker survey data has increased the probability of recession.
- Uncertainty over the trajectory of inflation and hawkish reaction by Central Banks is leading to volatility within fixed income.
- Falling prices across all major asset classes have not yet been accompanied by falling profits thus valuations may have further to decline.
- Investor reaction to the increased probability of recession is to seek out businesses with greater resiliency. Those with strong balance sheets, robust cash flow and less sensitivity to consumer retrenchment. Strong cash flow companies with resilient earnings streams are preferred.
- Volatility in core asset markets and FX are likely to persist as Central banks continue to tighten policy.
- Moves have been made year to date by TPP and our appointed managers to enhance the defensive nature of the portfolios. This remains a fluid environment thus we maintain a preference to hold diversified multi-asset portfolios.
- A key discussion topic being, when to start to add risk.
