Markets have recovered this year from their 2022 lows.
Global equities are up 7.9% so far this year yet the narrowness of the latest market rally which was driven by the belated realisation of the potential of artificial intelligence (Nvidia and Meta are up 160% and 117% year-to-date) is reminiscent of the “beta chase” that preceded the burst of the Tech bubble, writes Clémence Dachicourt, Senior Portfolio Manager, Morningstar Investment Management Europe.
Earnings resilience and better than expected macro data have compressed risk premia yet sentiment amongst investors remains bearish as many believe this rosy environment is about to roll-over.
Uncertainty is high and markets seem to have gone ahead of themselves
Fears of recession
Several reasons underpin this belief, the first one being that yields are significantly inverted, a consequence of monetary tightening and expectations of falling growth.
Three-month T-Bills currently yield around 5.1%3compared to around 3.6% for 10 year notes.
Under these circumstances extending your portfolio’s duration by buying long maturity bonds is quite expensive unless you believe a recession is imminent.
Tightening liquidity and credit conditions
The need to tame inflation has led central banks to orchestrate one of their most rapid and sharpest tightening of monetary conditions: over the past 18 months T-Bills have risen by over 500bps.
This led banks to tighten credit conditions which isn’t a good sign for credit spreads or earnings going forward. The latest senior loan officer bank lending survey suggest that half of them had tightened lending standards, a level which was only reached a couple of times before: during the covid crisis, at the beginning of the GFC, before the dot.com bubble burst and ahead of the savings and loans crisis in 1990.
Besides, the recent resolution of the US debt ceiling is likely to continue to dry out market liquidity.
Equity markets aren’t cheap
The 2022 equity market sell-off was mainly explained by falling valuations as corporate earnings remained strong. Since then, the tech-driven rally has meant that valuations have risen again leaving very little to no room for further valuation expansion.
Sell in May and go away
Cash yields are attractive
Cash is one of the oldest, easiest, and most underrated source of tail risk protection.
It fulfills three attractive and complementary roles: it provides liquidity, it is defensive and provides diversification particularly in a world where equity/bond correlations are volatile, yet it can also be used to play offense as it constitutes a source of dry powder to reinvest once valuations compress.
Cash can also withstand a wide range of economic regimes and market scenarios, which in the current scheme of things is quite handy. Contrary to bonds that will suffer in inflationary environments, cash has no duration so will not be impacted by rising rates. In deflationary regimes, cash will also do much better than equities.
This however comes at a trade-off: negative or no carry. Cash yields are attractive on a nominal basis yet US inflation is still at 4% leaving investors with a meagre real return.
Bonds could offer better returns and less downside
Whilst further rate rises cannot yet be ruled out, central banks’ tightening campaigns have left rates a lot higher and above their long-term inflation targets meaning that bonds not only appear much better value but are also in a good position to provide downside protection and diversify equity risk.
Let’s consider the trade-offs of sticking with cash over holding bonds.
If rates fall, a longer duration portfolio will provide you with better capital gains compared to cash. In this scenario, an investor holding cash will be also face the risk of having to reinvest at a lower rate in the future.
If rates rise, the higher cushion offered by current bond yields will provide compensation against the capital gains losses, leaving you with a better risk-reward overall.
How should you protect your portfolio?
Whilst further rate hikes cannot be ruled out, tail risk for global bond yields has declined with central banks nearing the end of their rate hiking cycles, helped by peaking inflation and tighter credit conditions.
Equity valuations overall aren’t particularly attractive. Rather than holding overvalued assets and risk substantial capital impairment, holding some cash, temporarily accepting some purchasing power erosion makes sense but this strategy has two major downsides. It won’t allow you to meet your long-term investment goals and you’ll have the difficult task to decide when to re-enter the market keeping in mind that equities will offer more attractive returns over the long term.
Determining the optimal asset mix in a portfolio requires a holistic analysis of your risk profile, liquidity needs as well as prevailing and potential investment opportunities. Finding the right answer to this question is very challenging as today’s markets remain unusually uncertain and subject to central bankers’ policy decisions.
Setting up an investment framework and following a valuation-driven approach to investing no doubt remains the most effective strategy to meet ones’ investment goals.
This article was written for International Adviser by Clémence Dachicourt, senior portfolio manager at Morningstar Investment Management Europe.
