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«We Recommend that Investors Start to Re-Risk»

Alpine Macro's Chief Asset Allocation Strategist Caroline Miller expects inflation and long-term interest rates to fall next year. In an interview with The Market she explains how investors should position themselves for this scenario.

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For investors, 2022 has been a year to forget so far. Stubborn inflation leaves central banks no choice but to tighten monetary policy aggressively, and the strong dollar is causing stress in many emerging markets. At the same time, the slowdown in the economy is becoming increasingly evident. Around the world, stock and bond markets have brought heavy losses to investors.

«I don’t agree that we are facing a world of 4 to 6% inflation on a structural basis, as a lot of the current inflation is the result of a confluence of negative supply shocks»: Caroline Miller.

«I don’t agree that we are facing a world of 4 to 6% inflation on a structural basis, as a lot of the current inflation is the result of a confluence of negative supply shocks»: Caroline Miller.

Source: Alpine Macro

«Right now, the Fed is still very much on a tightening path», says Caroline Miller, Chief Asset Allocation Strategist at Canadian research firm Alpine Macro, in an interview with The Market, which has been edited for clarity. The Fed needs more evidence of a slowdown in the economy, particularly in the labor market and wage growth, before it can reverse course, she says.

Still, Caroline Miller doesn’t think investors should reduce equity positions - on the contrary, she recommends gradually building risk positions. Looking ahead to next year, she expects inflationary pressures to subside, leading to a decline in bond yields. This, in turn, is positive for the stock market.

Mrs. Miller, how would you describe the current market environment?

Uncertainty is high and uncertainty breeds volatility and volatility causes correlations between asset prices to rise. For asset allocators, this makes building a diversified portfolio more difficult. I think we have less visibility on the trajectory of monetary policy, we clearly have less visibility on geopolitical developments, which gives rise to the fear of more exogenous shocks. Furthermore, there is uncertainty about the outlook for global growth beyond the energy crisis and tightening financial conditions due to China, the world’s second largest economy, being in a state of semi paralysis.

What are the consequences?

The outcome of all these risks is difficult to forecast. It shows up in the volatility of financial assets, whether you look at the MOVE Index, which is a measure of the volatility of US treasury yields, which is one of the most important prices in financial markets. And it shows up in an overshoot of the US dollar, which is very much a function of this global uncertainty. The valuation of the dollar is stretched partly because of its appeal as a safe haven.

In the past, such an environment of slowing growth and elevated uncertainty would have prompted central banks to ease monetary policy.

In isolation, in the low growth, low inflation world of the last twenty years, such a combination would argue for monetary easing. But we are in a period of high inflation. The number one priority of central banks right now is to bring that down, because the economy does not function effectively without price stability. In the stark trade-off between price stability and economic growth, policy makers are focused on restoring price stability even at the expense of growth.

What do you make of the recent speculation about the Fed abandoning its rate hikes?

First, I would say it tells you something about how exceptional our world is today. For example, on Thursday the Bank of Canada hiked interest rates by 50 bp instead of the 75 bp the market was expecting and that was characterized as a policy pivot. A world in which a 50 bp rate hike is perceived to be dovish tells you what a departure the current environment is from the recent past. The market interprets a deceleration in the pace of tightening as a pivot. But let’s be clear: That is a long way from a pause or an ease. Tiff Macklem, Governor of the Bank of Canada, was very clear in saying they continue to see the need for higher rates until inflation normalizes.

There has been a slight shift in the narrative though, right?

Central banks are acknowledging that tightening today is having the desired effect of cooling demand. Hence, it makes sense to slow the pace of rate hikes to assess the economic impact as we know that policy impacts growth with long and often variable lags. And keep in mind that the Fed’s tightening cycle only started in March. So, there has been a slight thaw in the narrative, in the sense that the sharp pace of rate hikes may have peaked, but a real pivot would also include a message about a lower peak in the fed funds rate.

And you don’t see that yet?

Right now, the Fed is still very much on a tightening path. They need to see more evidence of a slowdown in the economic data, particularly the labor market and wage growth, and they seem to accept that the cost of bringing down inflation is going to be weaker financial asset prices. Unlike in past cycles, the Fed has continued tightening into this increasing uncertainty and despite the recent derating in asset prices. That is a clear reminder that they are focused on bringing inflation down and not on calming markets. However, we would assign low odds to the Fed having to hike more than currently is discounted, which is a terminal rate of around 5% sometime in Q1’23. I want to be clear about that.

What are the implications for financial markets?

I think it means that good economic news is bad for markets in the near term. On the other hand, bad economic data might be good, because you need an accumulation of evidence that the economy is weakening, for instance evidence of falling consumer sentiment and a weaker labor market, in order to anticipate that a Fed pivot is imminent.

Would you recommend that investors underweight equities?

We think it is too late to de-risk. True, markets are volatile but in a few months’ time we could look back on this period and see that it was the bottoming process after a savage bear market. Coming into next year, if this is indeed going to be a year of declining inflation, disinflation is going to be constructive for capital markets as it lowers the urgency for the Fed to raise rates further and thus creates a scenario in which bond yields are poised to drop. And we believe that lower bond yields would be critical to supporting the equity markets. That is why I think it is a bit late to be super bearish on stocks. For long-term capital allocators, the opportunity cost of sitting on a mountain of cash is rising as more and more value comes back to stocks and bonds alike.

Are stocks and bonds again attractively valued?

I would say that a lot of bad news is priced in. And the prospect of supply-driven inflation declining quickly is going to be a source of relief for markets to the extent that it heralds the end of this tightening cycle.

Do you expect bonds and stocks to rally simultaneously?

The initial phase is going to be a return of what we have seen as the classic correlation between yields and stock prices. In other words, lower inflation is going to catalyse lower yields which is going to be supportive of equity multiples. We are going to see an unwind of the period this year where high inflation prompted big declines in both stocks and bonds. The mirror image of this is that disinflation can be constructive for both, yes.

Would that be the start of a new secular bull market?

I think it is too soon to say if we are forming conditions for a new structural bull market. I feel more confident in saying this bear market is quite advanced.

Your constructive view is based on inflation falling. Other strategists such as Russell Napier expect inflation to be structurally higher – in the range of 4 to 6% – in the coming years.

I don’t agree that we are facing a world of 4 to 6% inflation on a structural basis, as a lot of the current inflation is the result of a confluence of negative supply shocks, not a surge in organic demand. If you look at the prices of semiconductors, we’re going from a shortage to a glut, if you look at inventories at the retail and wholesale level, there is clear evidence that the Covid related spending binge on durable goods is over just at a time when supply is recovering. If you look at the cost of shipping and the volume of seaborne global container volume - it’s dropping. In the US, the housing market is already in a recession. To believe that we are headed for a structurally higher inflation environment you need to believe that the current macro policies are going to fail to destroy enough demand to bring inflation down. And our view is that the neutral rate of interest that is consistent with price stability and full employment is unchanged from the pre-Covid era. Therefore, financing conditions are already restrictive and likely to bring inflation down. I don’t think we are staring at a world with permanent 4 to 6% inflation.

After US treasury yields, the US dollar is probably the second most important price in financial markets. Do you see an impending end to the dollar’s strength?

Yes, but I do not think that it will happen via globally coordinated central bank intervention, as many speculate is imminent. I think it has to happen organically via a shift in Fed policy. One precondition for a sustainably weaker dollar is a peak in US treasury yields and a narrowing of the current US interest rate advantage over its trading partners.

And the other precondition?

The other is stronger Chinese growth. Weak growth in China and an overheating US economy have been the main drivers of dollar strength in addition to the safe haven flows. Now the real value of the dollar is stretched, while the US is running a large current account deficit. Once it is clear that the Fed is done, the interest rate spread will start to narrow and that will be the catalyst for a weaker dollar.

Is that your scenario for next year?

Yes, financial markets are currently pricing a very high level of short interest rates in the US for a long period of time, i.e. short rates remaining well above estimates of the neutral rate through 2024. But if we are correct that the economy is decelerating and therefore inflation is slowing quickly, then our bias would be to expect a shift in expectations about the trajectory of short rates and therefore a shift in the perceived longevity of this strong interest rate advantage of the US, which should weaken the dollar.

Given this economic environment, what would be your recommended allocation to equities for the coming year?

We recommend that investors start to re-risk. The US has been the place to be from an earnings growth perspective, a currency perspective, and a lower overall geopolitical risk perspective. China is in the grips of zero-Covid restrictions and a major consolidation of power and an authoritarian crackdown by president Xi Jinping. In Europe you have an energy crisis and a seemingly unavoidable consumer recession as a result of that. I think the moment to rotate out of US assets has to be driven by the expectation of a weaker dollar and stronger growth outside of the US.

Is this also a story for 2023?

That pivot point is coming some time early next year but there are lots of pockets of equity markets where the bear market is well advanced. It no longer makes sense to be underweight. Actually, I would be underweight cash, going back into some combination of high-quality bonds and stocks, with visibility on earnings and with reasonably robust balance sheets. And I want to be clear: we do not recommend investors go back into the liquidity-driven profit-less tech, meme and SPAC sectors of the market. There are many high-quality firms whose valuation multiples have been savaged by the sharp spike in interest rates. It is those companies where the multiple compression has been stronger than the deterioration in the earnings prospects which investors should focus on.

For now, you are happy with US stocks, but as soon as US yields and the dollar start retreating you would shift into international markets such as emerging markets and Europe?

Yes, though we would favor emerging markets over Europe.

Why?

The tightening cycle is very advanced in the emerging world and the inflation surprise index has rolled over, which means there is scope for a quicker pivot to easier monetary policy which would catalyse a drop in real yields, which will support risk assets. Also, asset valuations are lower in emerging markets. I don’t have great visibility on the energy policy mix for Europe yet. Furthermore, emerging markets have been more resilient than you’d normally expect.

In what sense?

Typically, a very strong dollar is catastrophic for emerging markets. And yet, we have seen periods this year where emerging markets have outperformed US equities. That is because EM currencies, particularly in Latam, are already cheap. Moreover, sovereign dollar-denominated credit spreads in the emerging markets universe typically widen with a strong dollar but they have narrowed in a few markets this year. Again, this is evidence that the monetary tightening cycle is very advanced in emerging markets which is attractive from a real yield perspective. Interestingly, Latin America with its commodity export strength has gotten very little credit this year. Earnings in the region have been stronger than in Asia and yet the relative forward multiple has favored the Asian markets. In a nutshell, we prefer Latin America over Asia within Emerging Markets and have a preference for EM over EAFE at the moment.

Are you not worried that a recession will depress commodity prices further?

We are structurally bullish on commodities on a two- to three-year horizon. Cyclically, commodity prices could come under pressure given slower growth but a lot of that has happened already. The terms of trades for the commodity exporters in Latin America have improved radically and yet those bourses have been given very little credit. There is a valuation cushion there even in an environment where the near-term cyclical outlook for commodity prices is subdued due to slower global growth. We believe it is a fine time to start accumulating those assets because the longer-term picture is that the energy transition is going to be very expensive and lengthy and the capital starvation in fossil fuel development is creating a long-term risk of shortages in many commodities that are still in high demand, because renewables aren’t going to be able to fulfill global energy demand any time soon.

What do you make of China? Is it still investable?

I think it is in absolute terms, because it is the world’s second largest economy and still likely to grow 4 to 5% per year. That is the path countries like Japan, Taiwan and South Korea took. Their growth miracle ended when they reached China’s current GDP per capita of around 10’000 to 12’000 $, but thereafter they still had a period when they grew by 4 to 5%. That is an enviable backdrop for earnings growth when you look at the G7-countries which are growing much more slowly.

But…?

I think the problem globally is that there’s been so much value created in markets where there is more visibility on policy and less perceived binary risk and uncertainty. There is a great asymmetry. Why, as a foreigner would you go into China where you can’t really say with certainty when the zero-Covid policy is going to end and the economy is ready to go? You don’t need to take that risk when assets are cheap in places where there is more visibility on government policy. That said, underlying macro policy – fiscal and monetary – is quite pro-cyclical in China, so a retreat from the zero-Covid policy would spark a violent rally in Chinese shares. Speculators with strong stomachs can position for that outcome. I don’t think China is uninvestable in absolute terms, I just think it’s tough to make the case that it’s worth the risk in relative terms right now, when you have plenty of opportunities elsewhere.

Caroline Miller

Caroline Miller is the Chief Asset Allocation Strategist at Alpine Macro. Prior to joining the company, she spent eight years with BCA Research, where she served as a global strategist and the chief advocate for the firm’s research around the world. Before that, Caroline Miller worked for UBS Global Asset Management, La Caisse de dépôt et placement du Québec, and J.P. Morgan Investment Management. She began her career as a fixed income and currency analyst at GMO in 1992. She holds an MBA (Finance) from INSEAD, a BA (History) from Harvard University as well as the CFA and ICD.D designations.
Caroline Miller is the Chief Asset Allocation Strategist at Alpine Macro. Prior to joining the company, she spent eight years with BCA Research, where she served as a global strategist and the chief advocate for the firm’s research around the world. Before that, Caroline Miller worked for UBS Global Asset Management, La Caisse de dépôt et placement du Québec, and J.P. Morgan Investment Management. She began her career as a fixed income and currency analyst at GMO in 1992. She holds an MBA (Finance) from INSEAD, a BA (History) from Harvard University as well as the CFA and ICD.D designations.