Asset Allocation now overweight fixed income

After the Asset Allocation Committee meeting held on 7 June, Waverton has made the decision to increase its allocation to fixed income, moving from a neutral position that was adopted in November 2022.

This increase comes after a period of rising yields since early April 2023, when concerns regarding potential contagion effects from the failures of SVB and Credit Suisse subsided, and the strength of economic data became apparent.

While we acknowledge the potential long-term challenges facing fixed income due to the substantial levels of debt issuance anticipated from governments on both sides of the Atlantic, we view the recent increase in yields as an excellent opportunity to tactically increase our exposure to this asset class. This decision is based on our expectation that economic growth will weaken throughout 2023 and early 2024, accompanied by a moderation in inflation. As a result, investors are likely to seek out safe-haven assets, and fixed income presents an attractive option in this context.

Waverton's economic and market framework, which serves as a tool to distinguish meaningful signals from market noise, forms the basis of our expectation for a bleak economic outlook. This framework analyses the interplay between liquidity, growth, inflation, and rates, enabling us to gain a deeper understanding of the macroeconomic landscape and identify potential mispricing opportunities.

Taking each of these in turn:

Liquidity: In 2023 thus far, there has been a notable increase in global liquidity, which has contributed to the rise in prices of risk assets. This surge in liquidity can be attributed to various factors, including the weakness of the US dollar and commodity prices. Furthermore, measures undertaken by the Federal Reserve to ensure stability within the US banking system, such as the expansion of its balance sheet and the drawdown of the Treasury General Account in light of the approaching debt ceiling, have also played a role.

However, we remain cautious about extrapolating this trend going forward. US money supply has been contracting at its fastest rate since the Great Depression. This contraction is a result of funds being redirected, through money market funds (MMFs), to central bank facilities like the Fed's reverse repo facility instead of being used for bank funding. Unfortunately, this has negative consequences for the real economy, as fractional reserve banking operates in an inverted manner. Moreover, the market is currently pricing in an additional rate hike in the US, expected to peak at 5.5%, which is likely to exacerbate this issue.

Source: Bloomberg

Examining the lending environment, prior to the collapse of Silicon Valley Bank (SVB), bank lending was already decreasing, as evident from Senior Loan Officer surveys. Although concerns surrounding regional banks have stabilised, we maintain the belief that these banks are likely to continue reducing lending while raising the cost of credit. This reduction in lending is expected to have significant implications for small and medium-sized businesses across the US, leading them to curtail their hiring and capital expenditure plans.

Source: Bloomberg

Growth: Early indications of credit contraction are already apparent in economic indicators, exemplified by the latest NFIB survey. This survey reveals a significant rise in interest rates paid, a decline in capital expenditure, and weakened hiring intentions. While global economic growth in Q1 2023 exceeded expectations and the strong momentum of the US economy has led economists to revise their growth forecasts upwards for 2023, we maintain a sceptical stance due to the ongoing deterioration of leading economic indicators, where the percentage change is a level historically associated with an impending recession. Despite the recent positive performance from risk assets, these indicators warrant caution within portfolios and suggest a potential slowdown.

Source: Bloomberg

Several prominent US consumer-facing businesses continue to highlight a decrease in demand for discretionary goods in favour of non-discretionary, which aligns with patterns observed during a recessionary period. On the corporate front, medium and large businesses remain well-capitalised. However, there has been an uptick in loan demand for working capital from small-sized businesses. This indicates to us that the surplus cash accumulated during 2021 and 2022 is starting to deplete. Additionally, the decline in profits as a percentage of GDP in the National Income accounts is suggesting the corporate sector is beginning to feel some pressure.  

Source: Bloomberg

Inflation: However, the negative connotation of poor liquidity and growth backdrop leaves us more confident on the short-term inflation outlook. Global headline inflation is trending downwards with leading inflation indicators, such as monetary trends, credit reduction, and supply chain analysis, suggesting that this should continue. We were particularly concerned about Core PCE ex-housing in the US, which remains above the FED's target, however, we believe this factor is heavily influenced by wage growth which is showing some signs of weakening. We remain sceptical that inflation can normalise without an economic hiccup leading to rising unemployment, given what seems to be increasing pressure on small businesses in the US.

Source: Bloomberg

Rates: We have seen significant volatility in rates markets. Despite progress on the inflation front, we believe the Fed is not in a position to take risks with inflation and will remain hawkish, given their focus on lagging indicators of employment and inflation. This risks a deeper recession as we will likely only see interest rate cuts if and when it becomes evident the US has entered a recession. We believe the FED is unlikely to cut interest rates just because inflation has normalised, as it will wish to keep as much cushion in place as possible to be used in an economic crisis.

Based on our assessment of the framework, we are increasing our allocation to fixed income by overweighting government bonds. We anticipate that these bonds will rally as the economic conditions deteriorate and inflation moderates. However, it is important to acknowledge the possibility of a more optimistic economic scenario unfolding throughout 2023. Thus far, economic data has been surprising on the upside, and although the impact of China's reopening has been disappointing, we cannot ignore the expected eventual recovery.

Governments have continued to implement fiscally supportive programs rather than scaling them back, which offsets the monetary tightness we anticipate. Moreover, longer-term fiscal initiatives are beginning to have an impact on the real economy. Our discussions with companies worldwide confirm the strength of the travel market's recovery (excluding slower recovery in outbound travel from China) and the robustness of the industrial economy in the US, supported by investments related to the CHIPS Act, Infrastructure Investment & Jobs Act, and Inflation Reduction Act.

Considering these factors, it is crucial to ensure that our bullish fixed income allocation has an appropriate margin of safety. In 2020, we deemed this margin to be very low, leading to an underweight allocation. At that time, the UK Gilt index had a duration of 14 years and a yield of 0.3%. This meant that a 1% increase in yields would result in a 14% capital loss, which would take 45 years of income to recover. However, the current UK Gilt index has a duration of 9 years and a yield of 4.5%. This implies that if we are wrong and there is a further 1% rise in yields, we would only incur an 9% loss, which would be recouped within 2 years. This provides us with a sense of adequate protection in case our view does not materialise.