Multi Asset Commentary Q4 2022

There has been no 'hiding place' in the last year. Bonds and equities have been unusually correlated. A typical 60/40 blend has returned approximately MINUS 20% in US$ terms as both asset classes have declined together.

• As Axel Weber, the former chairman of UBS and President of the Bundesbank, said recently, "I haven't seen anything like this in 50 years". Essentially, we have a regime change to a market dominated by inflation, not deflation risk.
• The so-called bond vigilantes have returned (where have they been all this time of government profligacy?) and are rightly demanding higher interest rates to lend money to the government. The regime change to inflation as problem rather than an aspiration is catching out institutions and corporates who lack the knowledge of how to react.
• The UK DB pension funds using leverage to 'hedge' interest rate risk via derivatives show sadly that 1. Some people never learn 2. The regulators are often pointless and late seemingly enjoying the sound of horses galloping across their paddock 3. There is a lot of damage still to be done to savings pools with extended risk positions prevalent. Other schemes in other countries will be similarly caught out.
• Inflation is stickier than it need be because fiscal and monetary policy look to be pulling in opposite directions in the big economies. Monetary tightening would ordinarily serve to reduce demand and lower price and wage expectations. The problem is that many governments are turning on the fiscal taps and negating the impact of higher rates. Inflation thus remains since SUPPLY of critical inputs is NOT the recipient of this government largesse, but 'stay at home' payments and subsidies for inefficient energy are. So, inflation will not be killed as quickly as it was in the 1980s.
• In the 1980s and our return from the insanity of the 1970s inflation, we at least had fiscal not getting in the way of a move to monetary tightening? It wasn't pretty then but inflation was brought down quite quickly. Our guess is that we do not see a publicised return to monetarism but we hope that central bankers start to look at the figures again.
• Volcker and Lawson in the UK had a lot of supply side help - eg North Sea oil came on stream, changes to union rules in both countries, and productivity enhancing working practices were pushed through. We then got the China labour supply as a source of (one-off) cheap labour in the 1990s as China entered the global market.
• Today we have none of that spare capacity. On the contrary, supply side impediments seem to be deliberately foisted on economies, working against the attempts to bring down inflation by monetary tightening. Trade wars, new oil leases at post WW2 lows, heavy and pointless ESG regulation, etc all hurt the supply side. Has the notion of an independent central bank outlived its usefulness? If we are going to have more government intervention, then at least it should be coordinated between fiscal and monetary?!!

We have a big problem currently and are at a crossroads.

• Fork in the road choice #1 - Financial Repression. Interest rates will need to go higher to kill inflation, but the level of debt is so high that annual debt service outlays at higher interest rates will soon surpass budget items such as defence and education. This is politically unfeasible and so financial repression beckons unless we get a more coordinated set of policies which can grow the economy. Financial repression means forced purchase of government debt at rates well below inflation and/or price controls
• Fork in the road choice #2 - a U turn from years of poor policy. Reduction in government spending, supply side inducements to invest, perform R&D and hire employees at higher wages merited by productivity. An end to subsidies for inefficient activity which does not add to the social fabric. Promoting Private Enterprise ~ PPE
• If you don't believe the danger of repression being imposed, read what Lael Brainard and Robert Reich have been saying about company profitability - they argue it is too high and the remedy is not more competition (Supply side) but more controls https://www.federalreserve.gov/newsevents/speech/brainard20221010a.htm Price controls have also been proclaimed by UNCTAD (part of the UN) as the way forward. Forced purchase of government debt can be imposed through 'capital adequacy' and 'risk' rules for pension funds and insurance companies. Bankers used to operate in the 1950s and up to the 1980s on the 3 6 3 rule. Borrow at 3%; lend at 6%; be on the golf course at 3pm. They were heavily restricted in what they could do and what assets they had to hold.

Both choices, PPE promotion, at the expense of government spending, and repression as pathways, will be painful short term but only one has a good long-term outcome.

MAP positioning

• On the basis that "we're all dead in the long run" and that you "may as well be hung for a sheep as a lamb" we suggest that rather than 100% cash, listed equities in fossil fuel energy pipeline companies, energy storage infrastructure, food and Ag, basic materials, defence companies, and transport and procurement companies should be a significant piece of your risk assets.
• Japan is cheaper than the USA and more dynamic than Europe. We also believe the Yen is becoming ridiculously undervalued. As oil prices rose 10x through the 1970s, the US market went nowhere whilst the Japanese stock market trebled. Leading Japanese companies delivered 20% per annum share price compounding in that pivotal decade for Japan. Pivotal because they adopted a sensible approach to successive oil price shocks.
• Short duration bonds are becoming attractive. Flat yield curves offer decent yields at the short end without duration risk. Corporate bonds are becoming more attractive.
• Keep liquidity/flexibility at hand so you can move quickly and easily. Unlisted is not less risky than listed since price volatility is not risk.
• Our fear is that we will take the 1950s pathway #1 and be told that "4% inflation is the new 2%" and that "the government is here to help". Investing in what we have suggested will help mitigate the pain.

Delft Partners October 2022