Bedrock’s Newsletter for Friday 2nd September, 2022

Friday 2nd September, 2022

Global bonds, as measured by the Bloomberg Global Aggregate TR Index, have now officially entered bear market territory for the first time in a generation. Indeed, the -20.4% decline since its 2021 peak is the biggest sell-off for this widely followed global bond index since its inception in 1990. For the past 30 years, those who held long duration fixed income securities and other rates-sensitive assets could reap the benefits of consistently falling yields. However, the coronavirus pandemic, the war in Ukraine, and the economic fallout from each of these epochal events have finally upset the applecart – at least in the short-term. Higher bond yields translate into higher discount rates for equities, higher opportunity costs for non-interest-bearing assets, like gold, and a higher cost of capital for all of us. The effects of rising rates are thus rippling through financial markets as expected and as they have through much of 2022. As of Thursday’s close, the S&P 500 Index is trading just below 4000, having fallen -7.9% from a high of 4305 in mid-August, while the rates-sensitive, tech-heavy NASDAQ Composite has dropped -10.2%, and the pan-European STOXX 600 Index has fallen -7.5% (in EUR). In commodities, gold is trading at $1709/oz, having declined -5.8% since mid-August, while Copper is trading at $3.41/lbs, down -8.1% over the same time period. Correlated moves, such as these, are the biggest risk to traditional balanced portfolios because they leave few places to hide (beyond dollars); and it takes considerable skill – and humility – to steer an even course in such an environment.

The trigger for the latest sell-off in global bonds was Fed Chair Jerome Powell’s short, sharp speech at the Jackson Hole Symposium on Friday last week. This meeting of the great and the good from central banking and academic economics has been held every year in Wyoming’s stunningly beautiful Grand Teton National Park since 1981. In recent decades, however, it has morphed into arguably the most significant academic conference in the world, particularly in the wake of the 2008 Financial Crisis when central banks accumulated vastly more power to drive markets through unconventional monetary policy such as quantitative easing (‘QE’). Still, on this occasion, the hawkish and downbeat message from US and European policymakers, on inflation and growth respectively, hardly matched the bucolic setting. In particular, Powell argued that bringing inflation back under control would “likely require maintaining a restrictive policy stance for some time” and that he favoured “acting with resolve now” to avoid the economic malpractice of the 1970s (when repeated cycles of tepid rate hikes hurt growth but failed to stabilise prices, necessitating higher rates every time, culminating in Volcker’s painful but necessary monetary radicalism in 1979-82). At last year’s symposium, Powell had described inflation as ‘transitory’ and presented an optimistic economic forecast for which he was later widely panned. This year, his much more hawkish stance was clearly an effort to break with that legacy. However, it would not be uncharitable to say that the Fed’s (and the ECB’s) inability to anticipate inflation in early 2021 and its subsequent failure to respond to rising prices later in the year has damaged the credibility of its guidance (perhaps long-term) and made a hard landing for the global economy all-but inevitable.

Notwithstanding the above, Powell’s comments did cause some big moves in global rates markets as previously discussed. Futures now give a 90% probability to a 75bps hike of the Fed Funds (i.e., the US policy rate) in September, and imply that the Fed Funds will finish 2022 at 3.76% (c.1.4% above the current rate). Markets then see the Fed Funds peaking just shy of 4.0% in Q1 2023, before dropping back to 3.58% by the end of next year. Should this forecast prove accurate – and if higher rates persist for some time – it would put a significant (further) squeeze on spending by households and corporates and cause the US and global economies to slow meaningfully. That growth is already rolling over should give us all pause as we look to take advantage of the compelling levels at which many risk assets are trading today. So too should developments in ‘Zero Covid’ China, where the government has decided to lock down Chengdu this week, and in European energy markets, where forward pricing suggests that a catastrophe is brewing (as discussed in the last letter). Moreover, market participants are not known for their strong stomachs – that is, unless the ‘Fed Put’ is in play – so severely oversold conditions can always move against you. And as we enter seasonally weak September, the momentum seems to be with the bears for now (even if the payrolls data released today presents a relatively rosy picture of the US jobs market). This suggests that our decision to buy portfolio hedges last month will prove timely. And yet we should not lose sight of the fact that bonds now offer a compelling level of income relative to recent history (and there are signs inflation is already peaking in the US), credit spreads are far wider than is needed to offset any likely default scenario should recession take hold, equities have re-rated (and massively so in some pockets), and there are powerful tailwinds behind certain metals (such as copper) due to restricted supply, limited CAPEX, and the demand created by the energy transition. Investors should continue to allocate capital for the long-term, even if hedges and tactical tilts can help to manage short-term volatility.


 

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