We find ourselves in a rather choppy macroeconomic environment with record inflation levels, rate hikes, and a new war putting particular pressure on Europe. In this scenario, it is natural to feel uncomfortable or even scared in uncertain or volatile times, but investing in such times can also present opportunities.
Hartwig Kos, Head of Investment Strategy Multi Asset & Solutions, at DWS and NN Investment Partners gives us their vision of how to build a robust and sustainable portfolio in uncertain times.
In volatile and uncertain times, it is difficult to decide where to invest. Many people often wonder what would be the best option in this context to invest their savings, for example. What options would you recommend?
– Hartwig Kos: One could easily make the case that the current environment where stubbornly high inflation rates undermine any nominal and fiat money related financial asset, reals assets such as equities and obviously real estate and infrastructure should be the obvious safe haven assets. Unfortunately, that has not been the case.
The reason for this disappointing outcome was undoubtedly monetary policy and the stark rise in interest rates. Excluding equities for a moment, it shouldn’t be a surprise that these real assets (real estate and infrastructure) reacted to this regime shift in the way they did. Through their financing most of these assets have – besides their “real” characteristics – also “duration” characteristics.
As many global Central Banks are tentatively approaching the later stages of their hiking cycles one can argue that some of these pressures might eventually fade away. Having said that, there might be some shaky six months ahead of us for real estate particularly. Higher refinancing rates, paired with rapidly slowing economic activity. This means, that some bargains on these real assets might hit the market in the coming months. So, this is a big investment opportunity in the waiting. Crucial for a private investor is obviously how it is financed.
Likewise, NN Investment Partners points out that they focus on areas where uncertainty is decreasing and assess which parts of the financial markets would be the first to benefit.
In the current context, they see inflation around the world reaching its highest level (excluding, for example, Japan and China). “Consequently, we have more certainty about the speed of interest rate hikes by the Fed in the US and the ECB in Europe and also about terminal rates, i.e. the Fed funds rate in the US and the ECB’s main refinancing rate in Europe”, details.
As a result, -they comment- volatility in rates and equities is decreasing, and investor sentiment is improving. However, uncertainty remains as to the length of the period for which these central banks will maintain these terminal rates.
“Consequently, in an environment of ongoing uncertainty regarding corporate earnings, economic growth and the depth of the next recession, we believe investors will focus first and foremost on carry asset classes, i.e. cash and Treasuries, emerging market government bonds, corporate bonds and local emerging market bonds”, conclude.
How can you distinguish the real risks among so much market noise?
– Hartwig Kos: It is difficult, because what can start as mere market noise, can easily transform into real risk. And often, the real risks factors can remain latent risk factors for a very long time. Equity valuation is a good example of that. While there are only very few points of reference that one can use in order to gauge where equities might go, the Equity Risk Premium (ERP) is the one most interesting at this point.
Given the ultra-low interest rate environment in the past decade the concept has become less relevant but has witnessed a little renaissance in the past few quarters. In a nutshell Equity risk premium is a valuation framework that looks to estimate the attractiveness of Equity markets relative to Bond markets. While the bull market in equities in the past couple of years has outpaced corporate earnings meaningfully, the low level of interest rates has kept Equity risk premium at reasonable but uninspiring levels. Now since bond yields have risen substantially the Equity risk premium has cratered.
This even though corporates are operating at peak margins, what is going to happen if earnings are finally starting to fall? So how does this matter in terms of a discussion about market risk? Usually, the idea that slower growth leads to less monetary tightening and is good news for risk assets is the so called “bad news is good news argument” that all of us have gotten well accustomed to. But what if, given the levels of the Equity Risk Premium, and the fact that earnings are at peak levels and a sharply slowing economy, bad news stops being good news?
– NN Investment Partners: The real risks remain the trajectory of global inflation and excessive tightening by central banks that may again lead to liquidity strains in financial markets.
To this must be added the downside risk to consumer demand, currently supported by still resilient labor markets and consumer confidence. The spillover effect of deteriorating global housing markets (including the U.S.) could exacerbate the recession, with direct and negative repercussions on consumer confidence and demand.
In China, in particular, consumer confidence remains weak and is directly linked to Covid policy and the lingering real estate crisis.
Fragility remains in certain emerging market countries, as fundamentals have not returned to pre-Covid levels, although we see domestic demand in certain countries improving.
More importantly, we remain vigilant to shocks stemming from rising geopolitical tensions, e.g. China-US relations or the Ukraine-Russia war.
In uncertain scenarios, you may tend to “swim against the tide” Is this something you recommend doing? Can you find attractive opportunities in these times?
– Hartwig Kos: Broad-based and upward grinding inflation that had been exacerbated by the conflict in Ukraine, as well as the stubbornly persistent post covid economic sugar rush, literally bullied every single central banker and in particular the Federal Reserve into hiking interest rates. The rapid hiking cycle that spreads across the globe has obviously left global bond prices in tatters, and the global business cycle is starting to slow down as well, sparking investors’ hope for an early end to interest rate hikes.
But, when thinking of the long-awaited and widely celebrated pivot by the Federal Reserve, one must ask the question what does pivot mean? Market participants have become so obsessed with monetary policy, that anything less than a 75Bps hike by the Federal Reserve is undoubtedly seen as a herald of a much more accommodating monetary policy environment. But even if the hiking increments become smaller, it doesn’t change the fact that rates are still rising, and monetary conditions are still being tightened. Whether this monetary policy-induced global economic slowdown will turn what was a terrible year into a fantastic year remains to be seen, but the odds seem in favor.
– NN Investment Partners: The Fed continues to tighten, and historically financial markets have bottomed out when the Fed has pivoted.
After Covid, financial markets moved even faster in anticipation of business cycle changes today, a Fed pivot can look different for financial markets and could be as subtle as a pause in hikes or a tightening of its monetary policy.
Especially in times of uncertainty, there are opportunities for investors. After many years of low-interest rates and spreads, both government bonds and (short-term) corporate bonds have become much more attractive.
We see opportunities in emerging market equities and Europe because they could benefit from the reopening of China. Within commodities, more specific exposure should be sought, as this time China’s recovery is not expected to be driven by consumption rather than investment (real estate, infrastructure).
