Nicholas Glinsman | February 16th, 2022
The thinking man’s global asset allocation model
The traditional global asset allocation model has provided a system of global asset allocation under four different economic environments. It looks simple, but beware – there are no shortcuts. As JFK once said:
“Too often we enjoy the comfort of opinion without the discomfort of thought.”
As such, we try to navigate our way around it with you and given the current environment, perhaps some changes therein are needed.
These are generic multi-asset strategies one would expect to employ under different US macro states. Right now, we do need to re-evaluate. Yes, we are certainly in the upper-right quadrant, but there are a couple of questions that perhaps imply change:
The need for the Fed to curtail inflation that is far above target has resulted in renewed market concerns surrounding stagflation and related investment strategies. However, the US economy is rather far from anything that might fit even a loose definition of stagflation, and in any event, stagflation has been a rather rare occurrence, as you can see below.
In November 2021 there was still questions about whether we were in a persistent “growthflation” state of the world, or, a short-lived “transitory” diversion from the Goldilocks, neither too hot nor too cold scenario. Four CPI reports later, and with some help from other price data, the emphasis has shifted dramatically to a view that growthflation will at some point transition to something akin to ” borderline stagflation”, a state we have not been close to for 40 years. Again the Fed will no doubt have the market believe this is very unlikely and in their March 2022 SEP update are likely to forecast a soft-landing for growth in 2023 and 2024. At least through H1 2023, that looks correct, for the longest reliable leading indicator, the yield curve is projecting a slowing, but some way from a recession signal in 2022.
The two charts below highlight the NY FRB’s relatively simple yield curve based probability of a recession, that using data through January was estimated at 6%.
FRB NY recession probability signal, based on the yield curve vs. the 10y – 3m yield curve
FRB NY yield curve signal on the probability of a recession versus the pattern of past recessions was 6% in January
The US curve typically leads GDP between 12-24 months, depending on the time period, so in that sense growth could well remain positive well into 2023 at the very least. The market recession chatter then appears premature, but will no doubt get more of a fillip as the curve flattens further. Crucially, all curve flattenings are not born equal. If inflation hits consumer spending (as it has already hurt sentiment), the curve will flatten in part via the back-end, which would be a bigger surprise and more worrying than a flattening being generated through the Fed’s actions at the front-end. A back-end flattening is the economy spontaneously slowing of its own accord and fits with a very low peak R and low R* world, while a flattening that comes from the front-end is a slowing driven by the Fed putting on the brakes, which has the advantage in the sense that policy at least is exercising more control, and the economy is strong enough to warrant higher yields. In any event, the present cycle’s curve signals will surely be different from the past. This is because QE was deliberately used by the Fed to distort and flatten the curve, and the relatively flat curve in H2 2020-21 was thereafter associated with much stronger nominal GDP growth than past cycles.
Beyond the relatively flat yield curve starting point for the upswing, as we shift away from QE, there will still be some stock effect from the Fed’s bond holdings that keeps the curve flatter than it would otherwise be, even as QT creates a reverse flow effect that supports steepening. These difficult to read cross currents/distortions, should make investors cautious in getting too excited by particular curve levels, and the difference between a curve that is small positively sloped or small negatively sloped. More important, almost certainly is the direction the curve is shifting; i.e. moving in a flatter direction, should be a solid 1+ year ahead signal for additional growth deceleration.
Another dilemma for the Fed and therefore the market is how the Fed deals with “the 2nd derivative trap”. It may not have felt like this at the Fed, but 2021 was the easy year for Central Bank decision making. Growth was accelerating, the employment gap closed rapidly, and inflation accelerated sharply. In part because of the policy errors of 2021 related to the magnitude of the inflation overshoot, it is almost certain that 2022 will include periods where growth and inflation rates have negative 2nd derivatives, and are both decelerating. In the context of this growth slowdown, the Fed will very likely have to make a decision when inflation is slowing enough to the point where they can pause hiking and still have confidence that inflation will move back to its target range within a reasonable time frame (+/- 2 years). This deceleration in growth and inflation is apt to make policy tightening more start-stop into 2023.
Even with stop-start policy tightening in/into 2023, the market appears to have priced too much of a hard stop to the Fed tightening cycle. i.e. the approximate 35bps of tightening priced for 2023 looks low, when placed in the context of a peak nominal funds rate a mere 2%, with a real funds rate still sharply negative – a combination which is unlikely to do enough financial conditions tightening to slow inflation by much. One of the greatest risks to developing bearish USD forecasts for 2023 and 2024, is that the US terminal rate that is currently hovering in the 2% area, is substantially (100bps or more) underestimated by the market.
Tightening the market has priced for G10 Central Banks in basis points for each of 2022, 2023 and 2024
So where does the above fit in with the macro investment global asset allocation model, and the appropriate investment strategy? Let’s bring a picture of the global asset allocation model back in:
So far, risky assets notably US credit and equities are the vehicles through which demand is restrained, and the Fed will need to tighten financial conditions substantially further. So, since November there is nothing new here. What is new is how the USD has missed an opportunity to take advantage of a sharp interest rate move in its favour this year. This is partly because the most material shift since November, is that the Fed is not the only game in town. Tightening expectations for all G10 Central Banks have been brought forward, most notably the ECB. Secondly, EM Central Banks have atypically been proactive, and regularly tightened ahead of the Fed in this cycle. This is particularly noteworthy given the Fed has been near the top of any list of accommodative Central Banks since Covid inspired QE, and is a reason why the US is near the top of global league tables on inflation problems. Some would argue there has been a role reversal with the Fed behaving less responsibly when it comes to inflation goals, that while it lasts, is intrinsically USD negative.
At a minimum, bringing the ECB’s tightening cycle forward, has
At that point, the large EUR area Current Account surplus will not have as its ‘natural’ foil to generate large capital outflows.
With regard to the investment strategies, two areas stand out:
With regard to commodities, our thesis is that the movement towards NetZero has seen policy commitment without a transition plan, creating a huge jump in demand therein, without adequate supply now or in the future, and critically regardless of the economic environment.
For example, the West needs to step up supply of copper for the energy transition. However, this is not just about copper, more about the supply-demand imbalances across a range of metals required to hit the COP26 targets, and yet there is no transition plan. Furthermore, you simply cannot transition away from fossil fuels on day 1, yet there is also a global supply shortfall therein pushing prices of this commodity group significantly higher, with feedthrough effects on both metals and agriculture.
It is the perfect storm for commodities in general, and I would posit that going forward, given the commitments of COP26, along with the Chinese making a similar push, long energy, base metals and agriculture should be a new shift for all four quads above.
As for EM FX, and EM markets in general, I am not so sanguine as the current conventional thought. Yes, some are arguing that EM markets already priced for the worst. As a group, the top 10 largest emerging market debt issues offer the highest inflation-adjusted (real) yields this century. Compared with the US high yield market, the spread is the widest since at least 2014, according to data from Bank of America. Moreover, in large economies such as Brazil, Mexico and South Africa, inflation rates show signs of peaking.
Yet the real test for these markets lies ahead. In March, the US Fed should raise interest rates for the first time in the pandemic era. While emerging market bond investors did reasonably well during the last tightening cycle, inflation then was less entrenched than today. Supply shortages for both raw material and labour refuse to go away. Worldwide, central bankers sound more hawkish on rates.
In the past, the big emerging market economies such as Brazil, Russia and South Africa had current account weaknesses that led to currency crises. This time the issue is fiscal. Debt as a proportion of gross domestic product has increased, even excluding China’s borrowing binge in the past decade. Since 2014, Latin America’s debt-to-GDP ratio has climbed by half to 75 per cent.
At the time of the taper tantrum in 2013, which triggered a sharp sell-off by catching many emerging market investors off guard, foreign holdings of EM bonds amounted to perhaps 45 per cent of new inflows from overseas. Today, foreign holdings easily exceed 100 per cent of those inflows, and not just for hard currency debt. In some markets such as Peru and Malaysia, foreigners own more than 40 per cent of the local currency bond supply.
The first of a series of US interest rate bumps is expected next month. So it is best to wait before trying to bottom fish in emerging market bonds, as we may be surprised at the downside, given the primary funding currencies are the USD and the EUR.
Putin is already close to victory in Ukraine
Russia has amassed foreign exchange reserves of $635bn, the fifth highest in the world and rising. It has a national debt of 18pc of GDP, the sixth lowest in the world, and falling. The country has cleaned up the banking system and has a well-run floating currency that lets the economy roll with the punches. It has a budget surplus and does not rely on foreign investors to cover government spending. It has slashed its dependency on oil state revenues. The fiscal break-even cost of a barrel of oil fell to $52 last year, down from $115 before the invasion of Crimea in 2014. It is the paradox of Vladimir Putin’s tenure that he runs one of the most orthodox policy regimes on the planet. The macroeconomic team at the central bank and the treasury are exemplary.
Putin’s tight ship a striking contrast to the prodigal socio-economic systems of the West, where money rains from helicopters and fiscal dominance prevails. He is extremely conservative and rails against the dangers of debt.. The commodity boom is adding an extra $10bn a month to Kremlin coffers from oil and gas. It is being squirrelled away in the National Wellbeing Fund. This rainy day reserve can be tapped as needed to cover social spending: pensions, child care, fertility bonuses for families, and mortgage subsidies for first-time buyers – components of Putin’s levelling-up strategy for the 2020s. The Kremlin could sever all gas flows to Europe – 41% of the EU’s supply – for two years or more without running into serious financial buffers.
The West talks of “devastating” sanctions if Putin invades Ukraine. Yesterday was the turn of German Chancellor Olaf Scholz to repeat the warnings in Moscow, meekly in his case. There is theatre to this ritual, at best wishful thinking, at times masking economic self-interest. The harsher truth was summed up by Russia’s ambassador to Sweden. “Excuse my language, but we couldn’t give a shit about western sanctions,” he told the Aftonbladet newspaper.
Washington says it will inflict much harsher punishment than in 2014, starting at the top of the escalation ladder. The Kremlin may already have calculated – accurately in my view – that the impact will in fact be less. Post-Crimean sanctions coincided with a secular commodity bust, the main reason why Russian real disposable incomes were to slide by 12pc. This time they coincide with a secular commodity boom.
Russia today has a semi-autarkic economy, and its chief trade partner is China. The copious document signed by Putin and Xi Jinping at the Beijing Winter Olympics – Entering a New Global Era – establishes a de facto authoritarian alliance. We should take the rhetoric with a pinch of salt. They remain two scorpions in a bottle, as amorous as Ribbentrop-Molotov lovers. But right now China has Russia’s back against the West, and this renders it impossible to enforce meaningful sanctions.
The Kremlin knows that Europe has vetoed the expulsion of Russia from the SWIFT network of international payments. The West has to do something to save face but we expect nothing more than sanctions on two or three large Russian banks. That would be disruptive but Russians are used to this. The only sanctions that would have any real impact is to try to kick Russia out of the global financial system altogether. Obviously Russia would grow faster if it were integrated into Western supply chains but in a sense the damage has already happened since Crimea. Further measures would be more of the same.
It is clear that there will be no blockade of Russia’s energy nexus. Germany’s gas dependence is so total that Olaf Scholz still cannot bring himself to state unequivocally that the Nord Stream 2 pipeline should be shelved after a full-blown invasion. Whatever is done requires the unanimity of all 27 states and will therefore gravitate to the lowest common denominator. Basically, Europe can’t do without Russian energy, and it has nowhere else to turn. This is not just about gas: there are oil pipelines, as well as 2.5m barrels a day of refined products like aviation fuel and diesel. Deliveries of liquefied natural gas, mostly from the US, have slowed the depletion rate of Europe’s gas reserves over the last month, with the help of mild weather. But they are uncomfortably low – Austria (19%), The Netherlands (24%), France (28%) – and global LNG capacity is stretched to the limits. A total Kremlin cut-off would bring Europe to its knees within weeks.
The White House thinks Putin cannot achieve his $400bn investment plan to diversify the economy over the next decade without Western technology, but China can plug many gaps, and there is no chance of sustaining a hermetically sealed sanctions regime at global scale. Putin has an unrepeatable chance to smash the post-Cold War settlement and reassert Russian dominance over its near abroad. Nothing on the current menu of sanctions will alter his calculus. If he steps back from an invasion over coming days it will be for one of two reasons. The first is that the US, Britain, and Turkey have shipped weapons to Ukraine that are sufficiently sophisticated to move the needle: anti-tank and anti-aircraft missiles, and drones. Nato’s Eastern European states have held firm. The US and the UK have mobilised their cyberwarfare capability on behalf of the alliance. Washington has made it clear that it will support a guerrilla insurgency to raise the tariff of military occupation. Putin has to weigh the risk that Ukraine’s battle-hardened reservists might put up stiffer resistance than expected and that a lightning strike on Kyiv might prove harder than it look
Almost nothing that core Europe is now doing has any bearing on this. The EU failed to heed the lesson of Russia’s seizure of Georgian territory in 2008. It continued disarming even as Russia armed further. It spent a decade obsessing over institutional architecture, and then trying to save monetary union from its own contradictions. It lost sight of the greater strategic imperative during the European debt crisis, when states slashed spending on modern weaponry to meet arbitrary and pro-cyclical austerity targets. These were enormous errors of statecraft. The other reason why Putin may desist is if Germany and France have promised behind closed doors to give him what he wants without a war: Ukraine on a platter, stripped of sovereignty and locked into Moscow’s strategic orbit. To call it Finlandisation is a euphemism. It is closer to Russification.
We will find out soon enough what has been going on in these private sessions but it was revealing to see the ashen face and involuntary wince of Ukraine’s Volodymyr Zelensky as the German Chancellor spoke in Kyiv. Scholz did indeed seem to be pulling the rug from underneath his feet, deflating Ukraine’s hope of genuine independence with the soft-spoken words and careful precision of an employment lawyer, the Chancellor’s former job. Markets are implicitly betting that a Western sell-out on Putin’s terms is the likely outcome, and that Ukraine will be pressured into “voluntary” realignment – like the Czechs in 1938 – allowing business to continue as usual.
Utter cynicism is usually the safest bet.