ADRIAN SAVILLE: Heed Cardi B and get hip to the hop of recession and tweak your assets
Investors can get a firm grip on stagflation by considering assets that are designed for the current economic reality such as gold, commodities and asset-backed private credit
Recession is coming. Even Cardi B knows. The American rapper and songwriter recently tweeted: “When y’all think they going to announce that we going into a recession?”
Readings on the economic barometer are materially different now than the beginning of the year, when the World Bank cheerfully pointed to 4.1% economic growth and 3.3% consumer price inflation for the global economy for 2022.
Since then, Russia’s invasion of Ukraine, coupled with China’s strict Covid-19 lockdowns and a world struggling to shake off the pandemic, have hit energy markets, supply chains, food prices, financial markets...and the price of Bored Ape Yacht Club nonfungible tokens (NFTs).
The forecast for world economic growth has been lowered sharply to 2.9%, and this could go lower still with the rising concern that the US economy is going into recession. Chinese premier Li Keqiang has indicated that the short-term goal is to prevent the world’s second biggest economy from contracting.
Behind the curve
Adding to the economic growth injury, the rate of consumer price inflation is now running above the target range in all 12 advanced economies that target inflation. The same goes for 27 of 31 emerging markets that have inflation targets. Yet markets and central bankers seem to be far more sanguine, seemingly taking a this-too-shall-pass stance.
The Federal Reserve Bank of St Louis’ five-year forward inflation rate (T5YIFR) suggests that consumer price inflation in the US will average 2.4% over the next five years. However, US money supply (M2) grew by a little over 40% over the last two years. Given Milton Friedman’s famous dictum that “inflation is always and everywhere a monetary phenomenon”, it is hard to reconcile the pace of printing in the US with this benign inflation outlook.
Further, although central banks have started to tighten monetary policy the punch bowl has been on the table for a decade or more. The Taylor Rule, which proposes how central banks should change interest rates to account for inflation and other economic conditions, suggests the US Federal Reserve should be targeting an interest rate of about 6.5%. Even with the Fed’s 75 basis point hike (bps) — the biggest increase since 1994 — chair Jerome Powell signaled interest rates would rise to 3.4% by December. This leaves the Fed — and other central banks — a long way behind the curve.
We cannot be certain of any economic forecast, but it seems the die is cast for a period of low economic growth and high price inflation. The implications are significant. Writing 100 years ago, John Maynard Keynes observed that “there is no subtler, no surer means of overturning the existing basis of society than to debauch the currency” and “the process of wealth-getting degenerates into a gamble and a lottery."
Then, even if central bankers wake up to the inflation reality, the policy instruments used to brake inflation have lags of up to two years. To add fuel to the inflationary flame, we entered this period with elevated expectations for corporate-earnings growth, and valuations on equities and bonds are meaningfully higher than the last hard monetary lockdown of the 1980s. The risks to global economic growth and investment values are high.
It seems the die is cast for a period of low economic growth and high price inflation.Adrian Saville, investment specialist at Genera Capital
We need a benign outlook if we are to expect conventional approaches, like the 60/40 portfolio, to produce positive real returns over the next five years. This time is different — and in a bad way — which requires a different investment approach. In this setting, it is hard to believe that “more of the same” and “hang on for the anticipated recovery” will cut it.
Off a cliff
If fair-value models have gravitational pull, it would not be surprising to see purchasing power parity re-assert itself after the dollar’s 15-year domination in currency markets. If this is the case, it means an important part of portfolio construction involves holding currencies other than the dollar. Also, a receding greenback would be positive for dollar-priced assets, including gold, precious metals and hard and soft commodities.
That said, the case for commodities is especially tricky, because recession can easily take commodity prices off a cliff. Arguably, exposure to dollar-priced commodities would be better managed by using long-short positions to capture mispricing, rather than trying to own structural drivers of commodity prices.
Given the vulnerability in credit markets, healthy doses of credit insurance also could pay off handsomely — especially in lower-grade credit markets where yields seem to be far too kind given the economic reality. In this vein, if the toxic stagflation cocktail sets in, asset-backed private credit could be one of the few investment classes that produces equity-like returns. However, this investment class requires commitments of five years and more, underlining the point that private credit only makes up part of a portfolio in an inflationary setting — or any other setting, for that matter.
When the winds of inflation blow hot and the tide of economic growth goes out, different assets and different business models are needed than the default stance taken since the end of the last stagflation. Businesses with products and services that are relatively insensitive to income and price inelastic — like healthcare firms, software as a service, utilities, and payments firms — could make for solid investments in tough times.
Business-development corporations with exposure to defensive industries could offer portfolio protection, and some capital growth, in the face of stagflation. By way of example, Ares Capital Corporation (ARCC) offers a well-diversified portfolio made of up 395 portfolio companies, trading at a discount to net asset value of $19.5bn and yielding 9.4% in dollars.
While policymakers fiddle with economic levers, investors can get a firm grip on stagflation by seeing the danger in the belief that “this too shall pass” and considering assets that are designed for a world in which Cardi B’s tweet becomes our economic reality.
• Dr Saville is an investment specialist at Genera Capital and professor at the Gordon Institute of Business Science.
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