Playing the hand that markets deal

The US is unlikely to return to a low-rate/low-inflation environment in the short term. Investors need to consider new tools in their pursuit of attractive risk-adjusted returns

A FORMER employer and mentor of mine once described his philosophy for portfolio management like this: Successful investors focus on making the best hand with the cards they're dealt. The corollary to that statement is that too many people in the investment management industry spend their time thinking about the way markets should be.

Today, I'm reminded of that lesson. Growth has been more resilient than many people expected. Healthy household balance sheets, combined with strong labour markets and growing corporate profits, largely fended off the challenges from inflation and central bank tightening.

In this column, we share how our views are evolving, given what is likely to be a US economy in transition over the next several quarters. If the first half of 2022 were a recession in the US, as many claimed, it will no doubt go down as one of the strangest in history. Despite two consecutive quarters of negative gross domestic product growth - the layman's definition of a recession - 2.7 million new jobs were created; the labour force participation rate improved; continuing jobless claims fell by 20 per cent; and corporate profits surged to a record high. I doubt that the National Bureau of Economic Research will deem it a real economic contraction.

Headwinds are mounting. They are reflected in falling growth forecasts and rising estimates of recession probabilities for the US, the UK and the eurozone.

A longer half-life to inflation

Inflation's persistence has been another surprise for many observers. However, several encouraging signs from recent US Consumer Price Index (CPI) reports suggest that July marked the peak for headline inflation. We can now look past the volatile categories that hit fast and are rolling off quickly, such as energy. There's also observable deceleration in price growth in certain stickier categories. For example, we've likely seen the cycle peaks in home price appreciation and rent growth, which are still high but moderating.

In the US, shelter inflation - which tends to be quite sticky - may not drift down as rapidly as market prices. Housing remains structurally undersupplied for the medium and long term, and the pipeline for new home construction is dry. Rental housing markets are equally tight, with historically high occupancy levels. Simply put, the US needs more single and multifamily housing units, and until we get them, demand seems likely to remain higher than the supply. 

This imbalance in demand and supply is important because shelter comprises around one-third of the overall CPI basket, and more than 40 per cent of core CPI, which continues to accelerate. With this backdrop, the focus for investors is how quickly inflation falls and what the run rate will be. They must consider how continued labour market tightness may slow the decline.

With more jobs added and initial jobless claims low and falling in recent weeks, tight labour markets continue to drive elevated wage growth. While the US civilian labour force has recently returned to pre-Covid levels, it remains more than 4 million people below the pre-Covid trend at the same time that there are nearly 4.5 million more job openings relative to pre-Covid levels. Even with further weakening in the labor market on a cyclical basis, the trends point to continued tightness on a more secular basis in the next cycle. 

Until the unemployment rate increases and wage growth cools, the Fed could be playing a giant game of whack-a-mole with inflation. In this game, interest rates are a blunt cudgel. The most likely path is slowing economic growth and a longer half-life to inflation.

Continued trouble for the traditional 60/40 portfolio

Markets remain too complacent. The efficient market hypothesis argues that all information is priced in. But there is an apt quote that says: "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

Stickier inflation, elevated wage growth and a higher cost of capital are all ingredients that place downward pressure on profit margins. A strong US dollar and a trend away from globalisation are additional pressures for large multinational companies. Despite all of these headwinds, analysts continue to forecast record profit margins for the S&P 500 next year. Those forecasts are likely to be revised further down in the coming months, along with those for earnings.

This bear market has the S&P 500 down to a 16x forward price-to-earnings multiple. But the drop is almost entirely due to price declines, as until quite recently, earnings forecasts remained elevated. But in every recession in the last 50 years, earnings growth declined by an average of around 10 per cent from peak to trough. I am sceptical that earnings growth will remain positive, so I'm wary of the rosy profits forecast, and the 16x multiple.

A 40-year trend of secularly falling interest rates has stalled, if not ended completely. Over that period, the average of global rates hit an all-time low. We are in the middle of one of the most coordinated tightening cycles in recent memory, with approximately 85 per cent of central banks hiking policy rates. Even so, rates are still low from a historical perspective. The recent rise in interest rates, while rapid, has further to go. One reason for that is a secular trend of underinvestment.

I am of the view that traditional fixed income will continue to be challenged by higher interest rates. Bonds, even those with higher interest rates, will just be clipping coupons, the real value of which will be lower because of stickier inflation. Equity investors will also be structurally challenged to achieve the returns of the previous cycles due to higher interest rates and the reversal, at least in part, of the unprecedented balance sheet expansions of major central banks.

I do not believe that the recent trouble for 60/40 portfolios is a one-time aberration. When considering diversification, it's important to remember that correlations are not static. They change over time, and they can remain positively or negatively correlated for long periods, especially in rising rate environments. In the late 1970s and much of the 1980s, when rates were high and generally rising, the correlation was strongly positive for a sustained period.

In my opinion, the US will not return to a low-rate/low-inflation environment in the short term, so today's positive correlation could persist for some time. Within that framework, investors need to consider new tools for their toolkits, so they can still maintain an edge in the pursuit of attractive risk-adjusted returns. Alternative assets are one such potential solution, as returns tend to be less correlated to traditional public market returns, and often have lower volatility.

The writer is the chief investment strategist at Blackstone's Private Wealth Solutions group. The views expressed in this commentary are his personal views and do not necessarily reflect the views of Blackstone Inc.



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