FERNANDO DURRELL: Looming hard landing for US could force the Fed’s hand

The stickiness of US inflation and the prospect of a hard landing have long troubled absolute return portfolio managers. These concerns were prominent as 2024 began, and remain top of mind in the second half of the year. 

Inflation above the 2% Federal Reserve target has two main consequences for financial markets: US (and global) interest rates would have to stay higher for longer, and US growth will come under pressure. The significant sell-off in global markets in early August suggests investors are recognising the risk of a potential US recession amid high inflation. 

A US-led global recession increases the probability of severe drawdowns on equity investments — a major concern for those with high global equity exposure. From an absolute return perspective, high interest rates support global cash and bond yields, creating a margin of safety that aligns with our fund mandates. 

Market uncertainty and the latest equity correction reduce the chances of a repeat of the S&P 500’s first-half outperformance. The six-month return from equities was skewed by the “Magnificent Seven” tech stocks, which delivered close to 40%, compared with just 9% for the rest of the S&P 500. 

Setting aside recent developments, our asset class return update for the first half of the year reflects the strong performance from global equities and a moderate uplift in the rand against the dollar. The chart of asset class returns shows far more green, making the one-, three- and five-year fund returns more palatable than the last time we updated stakeholders. 

Our goal for the SIM Inflation Plus Fund remains to achieve clients’ return targets by taking the least amount of risk possible, while minimising the probability of capital loss. One of the best illustrators of this is that our fund sits at the lower end of the volatility spectrum — far lower than equities and even lower than bonds. 

The asset class selection for absolute return funds is guided by a deep understanding of risk, with one measure being maximum drawdown. Drawdown represents the percentage of capital “loss” in a period; but this loss is not realised by an investor unless they sell out at that point. Historically, the largest drawdowns in traditional asset classes have been in SA listed property, followed by SA equities, the currency and SA bonds.

Volatility is evident in the top contributors and detractors in the SIM Inflation Plus Fund over the latest six months. Most returns came from local interest-bearing assets, sweetened by a small position in offshore equities, while detractors included local shares such as MTN and Sasol and offshore property. A similar picture emerges when unpacking the latest 12-month performance. 

Now to the fool’s errand of predicting the future. One chart in my recent presentation to the Sanlam Investments first-half fund update shows how steep hikes in US interest rates almost always lead to a US recession. The resilience of that economy after the latest Federal Reserve rate hikes has puzzled analysts. 

Business- and consumer-focused indices show that slowdown pressure is mounting, nearing levels that preceded significant market corrections such as the 2001 dot.com crash and the 2008-09 global financial crisis. Why so much concern about a potential US recession? 

The worst equity returns on the MSCI world index were linked to recessions — something that cannot be ignored. It matters to domestic investors and portfolio managers, too, because when the US and other developed market economies take a hit, emerging markets follow. Setting recession concerns aside, our team prefers SA equities over other emerging and developed market equities for now. 

Emerging-market bonds are attractive, with the real yields on offer from government bonds in Brazil, Namibia and SA at multiyear highs. Midway through 2024 the absolute return team prefers nominal bonds over inflation-linked bonds, we like enhanced cash, and remain wary of listed property. Note the first “hurdle” listed property has to clear is that of the yield on a nominal bond — and that is notably high at the current 12%-13% levels. 

The outlook for the rand is another key consideration. The currency is oversold, but with good reason. Global geopolitical risks should underpin a higher-than-trend risk premium on SA interest rate instruments over the coming year, explaining why local nominal bonds offer such high real yields, levels seen only four times in the past 25 years. 

It should come as no surprise that a significant portion of the SIM Inflation Plus Fund is invested in local short-term interest-bearing assets with about 30% in nominal bonds. We have also invested 9.2% of the fund offshore in bonds (3.7%); cash (2.1%); equities (2.1%) and property (1.3%). This asset class mix should deliver on our fund mandate over the coming years, insulating investors from the inevitable market volatility — and hopefully riding out the evolving US-led financial market contagion.

US inflation has not yet reached the 2% level the Fed desires, but the looming recession could pressure it to act sooner than intended. Before August we expected rate cuts in late September; now they might come earlier to prevent a recession. 

Recessions are often unexpected and painful, typically following periods of stability. Recent developments suggest an elevated risk of a US-led hard landing affecting the globe over the coming year. 

• Durrell is head of absolute return at Sanlam Investments.