By Fabrizio Quirighetti
Since mid-February, recession fears have receded, oil prices have stabilised, emerging market economies have bottomed out and risky assets have performed well. Central bankers have continued to upstage concerns over valuation levels and geopolitical risks, as very loose monetary policy has pushed prices higher.
While this has served to postpone or reduce deflationary pressures, it has failed, once again, to reflate the economy. In other words, the many troubles and concerns haven’t really disappeared; they have just been drowned again in the Fed’s massive punch bowl.
A difficult balancing act
As a result, we believe the Fed’s intentions are still the main market risk and driver.
It is a chicken and egg situation: the market’s expectation about the US’s monetary policy path makes it quite challenging for the Fed to actually normalise rates without automatically triggering the uncertainty that would in turn require easing back.
Fortunately, talk is cheap and we suspect Fed members will use rhetoric to ease or tighten at the margin, or at least restore some uncertainty regarding its intentions. Given the current strong consensus on an overall dovish stance by the main central banks, a few positive US economic data points, especially on the labour market, wages or inflation, may be enough to engender a re-pricing of assets resulting from a more hawkish Fed.
If we are right, it means that September may be an inflexion point to recent market trends: we don’t expect a strong reversal of these trends but just some pause. In this context, the dollar may stop weakening, rates should grind marginally higher, spreads shouldn’t tighten further and emerging markets outperformance could be challenged.
The last sip at the Fed’s punch bowl
While we are keeping an overall mild preference for risk, we are reallocating our preferences within our asset classes in order to benefit from a last sip at the Fed’s punch bowl.
The strategy is to concentrate our risk budget in European equities (especially banks), HY short duration bonds and emerging market local currency debt, where there is still some upside potential. We are reducing positions in current asymmetrical risk-reward assets, such as US equities, investment grade credit, emerging market hard currency bonds and gold, as these still carry some risks but haven’t any significant upward potential left based on our economic scenario and asset valuation analysis.
This risk reshuffling, which consists of selling and reducing the most expensive “risky” assets and marginally reallocating towards less expensive ones, may be seen in the same vein of our decision last month to buy cheap protection while keeping the overall portfolio risk stance unchanged.
This should help us to smooth the transition towards the end of this current party as the music volume has already been turned down somewhat and the punch bowl may soon be taken away. At least temporarily.
Fabrizio Quirighetti is co-head of multi-asset, and portfolio manager on the OYSTER Absolute Return fund at SYZ Asset Management