TradeTech FX 2023 kicked off today with a rousing Global Investment Outlook panel, in which speakers agreed that being humble and nimble was the way to go. Key conclusions: that emerging markets are exciting, equity is over, bonds are no longer ballast… and the US dollar could be riding for a fall (or is it?)
Humble and nimble
A characteristic of the market in recent years has been the element of surprise, and almost every panellist joked that they’d made bets that had gone wrong – whether that was misjudging the surging US deficit, undervaluing the dollar, or under-estimating the continued rate hikes. The important thing, they stressed, was to be humble – and to be nimble.
That’s translating into cautious asset allocation based on granular, strategic and easily reversible tactics – with key elements including a swing towards shorter duration bonds, a granular equities strategy, and a focus on the opportunities in emerging markets.
When it comes to credit, Brian Mangwiro, global fixed income and currency portfolio manager at Baring Asset Management, is long on one-to-three year but heavily underweight on the belly of the curve, on the assumption of a hawkish shift from the Fed. “If we’re wrong and rates continue to go higher, maybe the belly of the curve is the area that is mispriced – that’s how we’re positioned in our portfolio,” he said.
In FX though, the key is still to be responsive – because no one really knows which way things are going. “We’re nimble,” said Mangwiro. “We called the renmimbi weaker and it did weaken, but sterling and euro we really don’t know what’s going to happen. We have had a lot of expectations that have to play out, so we have to be ready.
Strategic asset allocation
The market must now adjust to a new macro regime in the wake of a prolonged period of low inflation and low macro volatility, shaken up in recent years by seismic events most notably including the pandemic, which sparked significant market shocks that have had both a medium and long-term inflationary impact. Near-term shocks including supply constraints and labour shortages in the US market, along with demographic trends such as an aging population, the move to net-zero, and ongoing geopolitical fragmentation are exacerbating the situation.
“It’s about where you are on the curve, positioning yourself for shorter-term exposure but also more granular exposure,” said Laura Cooper, international senior investment strategist at BlackRock. “Last November we went overweight in investment grade credit, then we trimmed that a few months later, and we’ve now gone neutral and if anything slightly underweight.”
But whichever path you follow, Cooper echoed that responsiveness is crucial. “In the past we looked at strategic asset allocation on an annual basis, but now we’re looking at it on a quarterly basis.”
Equity/bond shift
One of the biggest shifts is that investors are no longer relying on bonds as ballast. Instead, there is a move towards a more active management regime, as numerous pressures and influences come into play.
“We used to talk about cash drag but now with the yields we’re seeing you can park your money and still earn 4-5%,” pointed out Altaf Kassam, EMEA head of investment strategy and research at State Street Global Advisors. “Investors are voting with their feet, so it makes sense for us to remain at the short end.”
Equities are a different kettle of fish. But is it just a buy to hold play right now? “You need to be more nimble, more selective, taking on opportunity within this volatility,” stressed Cooper. “If we look at performance to date, under the hood there has been some dispersion, so there are opportunities to take on a more granular approach – whether by sector, factor, or on a regional basis. Ultimately though, investors are going to demand a higher risk premium to hold equities.”
“We like to drive from the macro,” added Mangwiro. “Key themes include the China/US divorce, for example. We’ve seen equities struggle there based on regional allocation. Korea has struggled, while Brazil is doing well in terms of commodities. We’re taking thematic exposure but we’re overweight, with a tilt towards the US, because that’s where the growth is. In the past we were just like, buy and go home – but now it’s a mix.”
Not everywhere is experiencing the shift towards active management though – so pick your battles. “In the US, just buy the index – it’s hard to find outperformers,” said Kassam. “Small cap is doing brilliantly in emerging markets, but hasn’t done well in Europe or the US for 10 years. You have to be selective in the way you think about equities.”
Emerging markets optimism
Emerging markets are a possible highlight on both sides of the coin. With many EMs on the verge of a pretty aggressive rate cutting cycle, they’re likely to start looking attractive again, especially compared to the anticipated slowdown in developed markets.
“If you want risk, keep an eye on emerging market debt – local currency for now, but people are buying the safety of the dollar and if that starts to crack, EM is going to see a nice pop,” said Kassam.
Smaller markets like Uruguay and Costa Rica as well as bigger players like Chile, Brazil, Poland and Hungary are all now moving to cut rates, and Mangwiro pointed out that “in sequence EM were first to respond to inflation – they peaked first, and now they are cutting. I think that bigger players will follow.We’ve been buying tactically. In Brazil we like the belly of the curve, for example, while in Chile we’ve been long duration.”
Others are also taking higher conviction plays around emerging market debt. “About a month ago, we rotated into hard currency,” said one panellist. “The growth dynamics have really surprised us.”
US economy
Of course, the US is always a central topic, and there are different views on what might happen in the American economy – particularly around a potential slowdown, and possible outcomes for the US dollar.
“How is the US likely to evolve?” asked Mangwiro. “We initially underestimated the fiscal programmes of the Biden administration, such as the Jobs Act, which was essentially the US taking its jobs back from China. When I first looked at that I thought they’d just paint a bridge in Minnesota somewhere, but it’s actually a big deal. Government expenditure has gone up by about US$1 trillion since Covid. The curve might still steepen, so we need to be careful.”
Cooper agreed on a cautious outlook focused on short duration, high quality credit and US treasuries. But “is now the time to buy the dip?” she asked. “The US backdrop is moderating. We’ve scaled back our inflationary view but we do think we’ll be in a period of stagnation, and we think yields still have some way to go on the curve. Our key conviction on SSA is around inflation-linked bonds. If inflation settles in the US at around 3%, that’s not accurately being priced in yet, so there is some upside there. That’s a key call for us.”
“In terms of creeping steepening, we haven’t even started to see that yet,” added Kassam. “The absence of the term premium is one indication of all this financial repression we have seen over the last 15 years – we need that repression lifted, we need to see volatility getting back to normal levels, where people don’t just react by buying the dip. When normal risk-taking behaviour returns to the market, then we’ll see the curve move back, but we’re nowhere near that yet.”
As another panellist noted: we’re still in a world where lots of money is chasing few opportunities, and we’re only at the start of the journey.”
In addition, there is an asset allocation towards private debt and private credit, with players taking on more exposure there due to perceived opportunities in response to the growing cost of capital for incumbent banks.
Dollar-driven
At the start of the year, the consensus trade was a short dollar – but although it did weaken for a few months, we’re now seeing another pop. Where’s it going from here?
“By all measures, for us, the dollar is over-valued,” said Kassam. “But we have to be humble, we’ve been calling it lower for 18 months but it hasn’t happened. That’s partially the carry trade, part risk aversion, part the flight to dollar safety, and also the surprising resilience of the US economy. There’s a lot of talk about Japan, the relaxation of yield curve controls, tough talk about the yen, but it doesn’t feel like the dollar’s exceptionalism is being sufficiently challenged to sustain a medium-term downtrend right now.”
But be warned – when curerncies are overvalued, they can move sharply in the opposite direction.
“I’m aggressively neutral,” joked Mangwiro. “But on a more serious note, we’ve got FX portfolios and we tend to be tactical more than strategic. Data suggests that on a cyclical basis, the market is short dollars. If the US continues to outperform the rest of the world (Europe weakening, China not doing enough to stiumulate the economy), then the dollar could run away. If US GDP comes in at 2% again next year, then that’s still a strong dollar environment. So we’re still long the dollar, tactically.”
That might change as the US economy changes though. At peak rates, the only thing that will push them higher is fiscal activism, which doesn’t seem likely to happen. Is the US economy likely to accelerate much further next year? If not, then a short dollar would seem sensible.
“We’re strategically short the dollar,” added Cooper. “The upside recently has surprised our expectations. We have a soft landing narrative, with a hawkish Fed driving dollar upside. Towards the end of the year there is still some scope for dollar to continue to outperform, as the Fed is keeping optionality to hike if they need it. But looking to next year, some of those growth dynamics are expected to fade.”
Overall, the panel expects that the euro should start to improve, while the yen is also likely to keep trading range-bound within 160-140 to keep the inflationary impulse. But sterling was universally panned. “The key call is always short sterling,” said one panellist. “I struggle to see any upside there on either a short-term or long-term basis.”
©Markets Media Europe 2023
