When Michael Burry bet against the US housing market in 2005, it nearly cost him everything. Back then, the hedge fund manager, whose story has been immortalised in the movie The Big Short, was in the minority. Ben Bernanke, the Fed’s chair at the time, famously stated weeks before the collapse of Lehman Brothers in 2007 that problems in the sub-prime mortgage market were unlikely to hit the broader economy. Only geeks and a few lucky short traders predicted a recession.
This time around, it’s different. The combination of rising inflation, overheated financial markets, strained supply chains and struggling household incomes makes this downturn widely anticipated. The alignment of macro-economic factors could not be any worse.
And the picture is especially bleak in Britain, where a shrinking workforce, trade worries and falling household incomes are looking so dire that the governor of the Bank of England, Andrew Bailey, has warned of an “apocalyptic” impact on food prices.
The Bank of England had already raised interest rates higher than in other developed markets when inflation hit 9% in May. With the hawks taking over Threadneedle Street, Washington and Frankfurt, recession is lurking around the corner.
According to Bloomberg’s economics survey, 40% of respondents believe there is a chance of a recession, while a Bank of America Merrill Lynch fund manager survey revealed that an overwhelming 71% of fund managers are pessimistic about the economic outlook.
But despite this gloomy forecast, simply de-risking by buying gilts is no longer an option for institutional investors, not least because bond markets are overheated following a decade of dovish monetary policies. Schemes are still under pressure to deliver returns. So, how does one invest in a downturn?
The ability of central banks to contain inflation will be the starting point for most investors. Whether rate hikes will succeed in reigning in price rises has repercussions across all asset classes.
At the same time, talks of rising interest rates bring back bad memories. In 1980, Fed chairman Paul Volcker raised US rates to an eyewatering 20%. Whether those measures were decisive factor in containing inflation remains disputed, but price levels did climb down to the lower single digits throughout the 1980s. But the rate hike came at a price. By 1985, US GDP growth had dropped to -3%. That is precisely the scenario many investors are now fearing.
Back in 2007, central banks managed to avert some financial pain by injecting huge sums of money into the economy and lowering interest rates.
But now they are gearing up for monetary tightening. Efforts to mitigate the economic damage caused by the pandemic have ballooned the Fed’s balance sheet to more than $8trn (£6.4trn), it now plans to reduce its assets by $30bn (£24bn) and subsequently $60bn (£48bn) per month, whilst also increasing interest rates.
Over in the UK, the Bank of England raised its bank rate to 1%. Higher borrowing costs will hurt businesses and consumers alike.
An early indication of that is the Red Flag Alert by Begbies Traynor, which tracks levels of corporate distress. The number of county court judgements in the first quarter increased by 157%, year-on-year, and the data provider predicts “a wave of business failures” due to the combination of fiscal and monetary tightening and inflation.
Richard Tomlinson, chief investment officer at Local Pensions Partnership Investments (LPPI), is convinced that rate hikes will eventually succeed, but remains worried about the wider ramifications. “Central banks will ultimately control inflation but the questions are: what path that takes, whether you end up with a soft or hard landing and if we will enter into a recession.”
While he believes it is unlikely that rates will reach similar levels to those seen in the 70s and 80s, he is nevertheless wary about the economic impact. “Since the end of the Second World War, we have seen 14 significant Fed rate hikes: 11 of which preceded a recession. If you are calibrating o that as your data set, the probability is that we will end up in a recession,” he says.
Jonathan Cunliffe, managing director of investments at B&CE, the organisation behind The People’s Pension, has a similar view. “My sense is that policy will be tightened sufficiently to get inflation down to 3% or so, which should be a satisfactory outcome for markets. Any attempt to reduce this to 2% would be ambitious and might put undue pressure on the economy.”
Others are more sceptical. Columnist Stuart Trow argues that monetary policy will have little impact. “People overestimate the power of using monetary policy to fine-tune inflation. It is largely a non-monetary phenomenon anyway. The real reason financial markets are losing their nerve is because interest rates have a much closer correlation to financial markets than they do to inflation.
“We have had extreme monetary policy on and off since the financial crisis in 2008, and this is the first time we have been worrying about inflation. And that’s for two reasons: one because global trade contracted sharply, and the other is the onset of Covid gave us fiscal policy measures. “Monetary policy has done nothing to trigger inflation, what it has done is pump up asset prices and when you are threatening to reverse that, you get panic in financial markets,” he adds.
Trow warns that monetary tightening could backfire. “At this point, central banks can only do harm because their relevance to consumer prices is almost zero. I am surprised that they have not woken up to that.”
Both Trow and Tomlinson believe that de-globalisation – a topic explored on pages 22-24 of this issue – will be a driving factor in keeping price levels elevated. “It feels like we’re in a de-globalising world and it’s difficult to see how that isn’t inflationary. It used to be about the lowest cost of production anywhere in the world. But now the cost of shipping is going up and the threat of new green taxes are pushing up prices too. Driven by concerns over the security of supply and national security, we are likely to see a shift to more local production which probably will mean higher costs,” Tomlinson says.
The problem has been recognised by Andrew Bailey. Speaking at a House of Commons Treasury Select Committee in May, he predicted that UK inflation could hit 10% this year and that the Bank of England would be unable to contain it as it is largely driven by global factors, energy prices, in particular.
But being in the firing line of the political blame game over the rising cost of living, Bailey also, somewhat paradoxically, pledged that combating inflation would be his key priority. The tacit acknowledgement being that this might require sending the UK economy into recession.
Stock markets: From growth to value
All this should be bad news for stock markets. Nevertheless, while the first three months of 2022 were tough, investors have not exactly stampeded out of shares. Indeed, equity funds in Europe booked some €28bn (£23bn) in inflows.
Among developed market stocks, tech heavy incidences such as the S&P500 have been hardest hit with the US index down more than 15%, year-to-date. But that still only brings it to 2021 levels. When analysed over 30-years, it remains at peak levels.
Other indices, such as the income-heavy FTSE100, have even bene ted from investor caution. Year-to-date, the British stock index is up marginally by 0.07% and over a year has risen by 6.7%. This could be an indication that rather than exiting stocks altogether investors appear to be focusing on income instead of growth.
That is despite stock markets being the most bearish of all major asset classes, according to a JP Morgan survey. Stock markets have priced in a 70% probability of recession, compared to 50% in investment-grade debt and 30% in high yield, according to an investor note by JP Morgan Strategist Marko Kolanovic. He believes stock markets are overpricing the risk of recession.
Speaking to UK institutional investors, it transpires that they are far more cautious, but those who have significant stock market exposure – local government pension schemes and DC Master Trusts, in particular – are not considering reducing it dramatically. At the same time, a strategy re-orientation of sectors is certainly on the cards for some.
For Cunliffe, of The People’s Pension, responding to short-term market challenges is not in the interest of his scheme, which has a long-term investment outlook. “The demographic of our members supports a long-term approach, which includes a clear ESG strategy,” he says.
“Our default proposition heavily invested in assets which enjoy the benefits of economic growth. While recent asset performance has been disappointing, we continue to believe that investment returns tend to mean revert in the longer term, which supports a relatively heavy weight to equities and other growth-facing assets from a strategic asset allocation perspective.”
In its growth oriented default funds built for relatively younger members, the master trust has more than 80% of its portfolio invested in equities and more than a third in US stocks. Year- to-date, the fund’s performance has slumped to -5% in March from 4.6% in January. It has since recovered somewhat and stood at 1.46% by the start of April.
While the master trust has not changed its overall equity exposure, it has made changes to the factor allocation. “We are, in relative terms, overweight in value stocks and underweight mega cap growth stocks,” Cunliffe says. “This approach should continue to bene t from an environment of rising bond yields and high inflation.”
Nest, the £24bn master trust, is anticipating a more challenging environment by slightly reducing its exposure to tech stocks and diversifying into alternative assets. Compared to last year, the 2040 Retirement Date Default fund slightly reduced it’s weighting on tech stocks but has so far refrained from reducing its exposure to stocks all together. By the end of Q1, they accounted for half the default fund’s portfolio.
This cautious outlook on stocks is also embraced by LPPI’s Tomlinson: “For [schemes] like ours, the aim is to build a portfolio that can survive in a range of different scenarios. We tend not to make significant tactical asset allocation moves is response to changes in the macro-environment but will time entry points for long-term allocations. Having said that, within each of our asset classes we do alter the asset mix based on the macro backdrop.”
Risk modelling plays an important role Tomlinson adds: “We are constantly thinking through plausible scenarios and how they may impact our portfolio. It’s about building an all-weather portfolio and not placing too much emphasis on a single scenario. We believe the best approach is to be macro-aware, rather than being macro-driven, because a kneejerk response can go very wrong. We will always ask ourselves, what is the probability and impact of any view being wrong?
“Our investment philosophy means that we have a broadly diversified global portfolio mostly exposed to the more defensive end of each asset class. We’re generally not in the most aggressive names within equities as we invest in higher-quality businesses with long-run pathways to sales and earnings growth. That means we have missed some of the upswing in tech names, but we have also avoided an awful lot of pain recently,” he adds.
For example, LPPI’s Global Equities Fund, of which 45% is managed by the in-house global equities team, uses the MSCI World as benchmark but has a relatively lower exposure to US tech. Apple, Amazon, Microsoft, Meta, Tesla and Alphabet are the biggest constituents in the MSCI World, accounting for some 15% of the index.
In contrast, only Microsoft features prominently in LPPI’s Global Equities Fund. From 1 January to 29 April this year, the LPPI Global Equities Fund has performed 7.7%, compared to 6.1% for its benchmark. The internally-managed global equities portfolio is up 9.6% for the same period.
“In a recession, you would have to worry about the non-profitable tech companies because they often rely heavily on financing to survive. And if financing lines are not freely owing, there will likely be some tough conversations going on,” he says.
But by far the biggest risks are seen in fixed income markets, which Trow, a former credit strategist at the European Bank for Reconstruction and Development, describes as “overheated”. This is a particular challenge for de ned benefit (DB) schemes to navigate as they tend to have the vast majority of their assets invested in fixed income.
In theory, rising interest rates should be good news for fixed income investors. Rising yields have certainly had a beneficial effect on the calculation of DB deficits, which overwhelmingly have moved into a surplus.
But inflation, which is dangerously high, could bring all this to a towering halt. With prices rising at 9%, it is hard to see how conventional gilt yields paying 1% to 2% could be attractive, unless they are hedged. It is no wonder then, that bond funds across Europe booked more than €40bn (£33bn) in outflows in Q1, according to Refinitiv.
“The bond market is much more of a bubble than the equity market. And for that reason, a lot of fund managers, including pension fund managers, are probably overexposed to equities, simply for a lack of viable alternatives,” says Trow, who believes quantitative tightening could make bonds more attractive again, at the peril of stocks.
“No doubt, fixed income has been hammered this year,” acknowledges Tomlinson. “But over the longer term, it really depends on where inflation is heading. It’s not a zero-probability scenario that inflation will start moderating. If that is the case and we end up in more of a grinding recessionary environment, then bonds actually might not be so bad. Most of the bad news may already be in the price,” he says.
“Right now, nobody wants to catch the falling knife,” Trow says. “But if you get to the situation where short-term yields in the US are 3% and longer-term yields are 4%, then all of the sudden you have a viable alternative to simply putting cash ow into equities.”
In the meantime, mitigating inflationary damages to the bond portfolio remain a key priority for investors. For The People’s Pension, this means reducing interest rate sensitivity and credit exposure in its fixed income portfolio, while the LPPI’s bond exposures are fully hedged.
But there are some snags to that. For one the supply of index linked gilts, the most popular asset class to hedge inflation risks, has been limited while demand from DB schemes looking to de-risk keeps growing.
At the same time, while linkers have offered negative yields for the past few years, as the Bank of England raises not only nominal but real rates, prices for linkers had fallen dramatically by the beginning of this year.
“Index-linked gilts can be extremely volatile and the empirical evidence for this shows that the 1/8% 2052 Treasury has exhibited price volatility of 23% in the past year. This is greater than UK equity,” says Con Keating, head of research at BrightonRock, and John Spain, a treasurer at education charity Law for Life, in a blog for Henry Tapper.
They both warn of “catastrophic losses” due to falling prices. Ironically, while linkers performed well in a low yield environment, they fall short of addressing the challenge they were meant to address: inflation.
No easy answers
Amid a gloomy macro-economic outlook, it appears that investors have no place to hide. For now, schemes with a longer-term investment horizon plan to weather the situation without a significant reduction of their equity portfolios, given that bond markets also face a challenging environment.
But equity portfolios will have to be adjusted if they are to face the coming storm. For Tomlinson, that means not only a strategic focus on income, but also increasingly factoring in currency risks. He predicts that amid growing global volatility, the dollar is going to rise. “Historically, when markets get ugly, the dollar tends to perform strongly, so we like owning a reasonable amount of dollars in our portfolios,” he says.
For example, the LGPS pool’s Global Equities fund is dollar denominated to capitalise on the rising currency. Looking at the global macro-economic outlook, he says: “There’s a reasonable chance it could be pretty rocky for quite some time. We have a portfolio that we expect to capture upside in the event of continued growth but should moderate the downside losses if things aren’t so rosy.”
Others, including Nest, see diversification as key. “We have been increasing our allocation to assets that are more resilient to inflation, such as commodities, property and infrastructure,” says Nest’s CIO Mark Fawcett. “But the important thing to remember is that pension savings are for the long term.”
While the exact timing of the next recession remains unclear, investors are under no illusion that they are about to enter a much more challenging environment. For what it’s worth, Michael Burry, the protagonist of The Big Short, has now built up a $36bn (£29bn) bet against Apple and this time around, he may not be the only one.