Rising inflation and slowing growth.
It is the bitterest of the various economic cocktails, and we think fear that it is the only one currently on the menu has been the main cause of market volatility over the past month. Supply-led inflation shocks and concern about China’s growth engine appear to be the main ingredients. Stir in a grudging and only temporary Capitol Hill compromise on the U.S. debt ceiling, and we see investors really start to turn their noses up. The S&P 500 Index has suffered its first 5% drawdown for a year. Core government bond yields have jumped.
We think it is easy for the current, difficult inflection point between post-pandemic recovery and steadier, mid-cycle expansion to obscure what are still strong economic fundamentals. That said, we also acknowledge scope for this period of volatility to persist over the short term.
For the first time in 18 months, our Asset Allocation Committee (AAC), whose latest Outlook is due out shortly and will be discussed in a webinar tomorrow, has started trimming risk in its views to navigate the coming weeks. But which markets do we favor, when core government bond yields remain so low?
So far, we are seeing a growth plateau rather than a steep descent. There is a thick cushion for a soft landing, in the form of big cash balances within households and corporations, rising wages, increasing capex and very accommodative financial conditions. But short-term uncertainties have piled up.
The ongoing Evergrande collapse, on top of the recent flurry of regulatory pivots, has raised questions about China’s role as the world’s growth engine.
The U.S. debt ceiling cliffhanger has been postponed for six weeks, but that still leaves the market trying to figure out who the winners and losers are from President Joe Biden’s massive, and still hotly debated, “Build Back Better” tax-and-spending plan. This plan could play out over a decade or more and reach into virtually every corner of American life. But at the same time, its effects are likely to be balanced against a negative fiscal impulse worldwide as emergency pandemic measures are withdrawn and expire.
It could take markets some weeks to process these question marks on growth potential.
Not Just About Gas
Then there are the inflation concerns.
Last week witnessed some extraordinary moves in natural gas markets, capping a period of rapid price rises. U.K. prices have doubled in three months; European futures prices have tripled over four months; and U.S. futures closed at their highest level in 13 years.
But this is not just about gas. Purchasing Managers’ Index reports revealed supply-chain disruption and bottlenecks worldwide. Eurozone input prices are rising at the fastest rate on record. U.S. companies reported capacity constraints and difficulties attracting and retaining workers. In Friday’s U.S. payrolls data, once again we saw somewhat disappointing jobs growth paired with a jump in average hourly earnings inflation, to 4.6% year-over-year, reflecting a tightening labor market.
Some of the worst of this is likely to ease over the coming weeks and months, but, as Brad Tank explained last week, and as long-dated government bond yields and breakeven inflation rates appear to reflect, there are a number of reasons to expect a portion of these price rises to prove very sticky and structural. Again, processing that could take weeks of volatile price discovery.
Creative Asset Allocation Thinking
That is why the AAC has turned more cautious with its short-term views. But what does “turning more cautious” mean, when government bond yields are so low? As we suggested a few weeks ago, when contemplating how to find diversification in a world unsuited to the 60/40 approach, it takes some creative asset allocation thinking.
For us, it involved upgrading our views on cash and select hedge fund strategies, especially event-driven and insurance-linked strategies, as well as maintaining our preference for private markets. Perhaps less obviously, it meant downgrading our view on U.S. large caps in favor of non-U.S. developed and emerging markets: While these may not be lower-risk in terms of their gearing to global growth, they may be lower-risk in terms of current valuations.
We think this more cautious stance represents a prudent approach to an already volatile inflection point between early-cycle recovery and mid-cycle expansion. When the dust clears, we believe markets are likely to readjust to a fundamentally robust medium-term economic picture—but caution today may make it easier to take advantage of the opportunity tomorrow.
Register here to listen to Erik Knutzen and Haka Kaya discuss these and other Asset Allocation Committee views on Tuesday, October 12, at 10:00 AM ET/15:00 BST.
In Case You Missed It
- ISM Non-Manufacturing Index: +0.2 to 61.9 in September
- U.S. Initial Jobless Claims: +326,000 for the week ending October 2
- U.S. Employment Report: Nonfarm payrolls increased 194,000 and the unemployment rate decreased to 4.8% in September
What to Watch For
- Wednesday, October 13:
- U.S. Consumer Price Index
- FOMC Minutes
- Thursday, October 14:
- U.S. Initial Jobless Claims
- U.S. Producer Price Index
- Friday, October 15:
- U.S. Retail Sales
– Andrew White, Investment Strategy Group