Talking Heads – Angriff oder Verteidigung in Multi-Asset-Portfolios?

This is an edited transcript of the audio recording of this Talking heads podcast

Daniel Morris:

Hello, and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis through the lens of sustainability on the topics that really matter to investors. In this episode, we’ll be discussing positioning multi-asset portfolios. I’m Daniel Morris, Chief Market Strategist, and I’m joined by Mark Richards, Head of Multi Asset Flexible and Absolute Return.

Welcome, Mark, and thanks for joining me.

Mark Richards: Hi, Dan, it’s a pleasure.

DM: So, Mark, if we look at the economy and the markets, one of the main current themes is the anticipation of a recession. There are indicators in the market that it’s coming but it never seems to arrive. Part of the confusion may be that growth, certainly in Europe, has been better than expected. On the other hand, growth in China has disappointed. All this is happening as the central banks raise interest rates to slow growth, so the big question is whether that leads to a recession. The market seems to be pricing the US Federal Reserve (Fed) as being at the end of its [tightening] cycle and looking for rate cuts reasonably soon. How do you assess that expectation and what do you think the economic impact of the hikes has been up to now?

MR: It feels like it’s been about 12 months since some kind of recession has been the base case for most multi-asset investors and macro economists. I think it’s important to focus on how the different sectors of the economy respond to the change in interest rates we’ve already seen, and how important they are for the reaction function of the Fed and other central banks.

If we look at some of the major components of the economy, the housing market is the most rate sensitive in terms of proportion of GDP. Residential construction peaked two and a half years ago in the US, after which there was a marked slowdown in growth. But now that rates have stabilised and the market is expecting some rate cuts, we’ve seen housing market activity pick up.

The sequencing of the economy’s reaction to interest rate hikes is straightforward. The rate-sensitive areas of the economy move first and the labour market moves at the end. So the bull case for equity and multi asset investors has been predicated on the fact that despite one of the most aggressive tightening cycles we’ve ever seen, the labour market has been bulletproof.

The risk of having recession as a base case for 12 months is that people give up on that view now that the housing market has been improving so far this year in the US. We think that would be too bold a step to take, as we are now seeing some signs of cracking in the US labour.

We can certainly be optimistic about some elements of the economy, and retail sales beat expectations earlier this week. But some of the leading components of the labour market – hours worked, overtime hours, temporary employment – in some of the more cyclical sectors of the economy have certainly shown signs of weakening.

DM: These contradictory indications come on the back of an almost unprecedented combination of a global pandemic plus massive quantitative easing and fiscal stimulus, which makes it difficult to understand what’s going on. So how might this cycle be potentially different given that the environment is clearly different?

MR: We need to look for the structural imbalances, which are always different from one cycle to the next. There was huge speculative activity around the tech bubble bursting, then massive household indebtedness around the Global Financial Crisis (GFC).

This time it is clear that the imbalance is in the undersupply of labour after the pandemic, and the synchronised emergence of the pandemic itself. The three major areas of the global economy – the US, Europe and China –came out of Covid at a different pace and a different time, which really messed up supply chains. So companies had problems managing supply chains, perhaps overbuilding their inventories. They also had hiring difficulties coming out of Covid, often hoarding labour out of uncertainty.

The big structural change in this cycle has been inflation, which is partly the function of the supply chain problems and partly a function of other longer-run secular forces around demographics and globalization.

Those are the three key elements: The undersupply of labour, the decentralised economy and the structural change in the inflation backdrop. What’s very interesting about the current situation for many equity market investors is the strong profit performance we’ve seen, both coming out of Covid and even in recent quarters, where profits have beaten expectations.

We should analyse how much of that is pricing power and how much is volume. We’ve never had this problem in the past 20 or 30 years because we’ve had a low inflation environment, so we only had to think about the real side of the economy.

Now, with structurally higher inflation, it’s harder to disentangle things. But if we look at some of the sectors and company reporting season details, it’s clear that pricing power has been dominating. It’s much easier for a company to pass through a price hike if inflation is running at five, six, seven or 8% than at one or 2%. What we’re seeing now is that the inflation momentum is slowing slightly and the volume data has been a bit softer.

That is a concern because companies have been able to hoard labour because profitability has been so strong. Without that, they will probably play closer attention to their labour force, which could impact on that key pillar of the bull case and the economy could start to fall away.

DM: Your job ultimately is to pick the assets that you anticipate outperforming, even in this unprecedented environment. What’s your assessment of how markets are likely to move in the next few months?

MR: There are two additional wild cards we should touch on in the very near term – the debt ceiling debates in the US and the issue around regional banks. I expect that both of those can be resolved without them being systemic. That could provide some relief, and rally risk assets and lead to some near-term selling off in government bonds. Both of those will likely provide opportunities to go the other way. So through the second half of this year, we will be looking to add to defensive positions within fixed income and reduce some of the positions we have in equity markets.

DM: Mark, thank you very much for joining me.

MR: Thank you, Dan.

This is an edited version of a discussion on current market events and is not intended as investment advice or an offer of products or services by BNP Paribas Asset Management. Please keep in mind that the information and analysis in this presentation is only current as of the publication date.