Turning, Not Re-Turning

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class, Managing Director, Neuberger Berman

It makes sense to prepare for the turning point in this cycle—but not by returning to the winners from the last cycle.

Our Asset Allocation Committee just wrapped its quarterly meeting—stay tuned for its latest Outlook in a couple of weeks’ time—and, as usual, we started by reviewing what we said three months ago.

While much of what we forecast about economic conditions was correct, financial market performance—especially in equities—was not necessarily consistent with expectations.

We believe the explanation tells us something important about the approaching turn in the cycle, and how to prepare for it.

Breakages

Coming into 2023, the Committee said that inflation would be surprisingly sticky, forcing policy rates higher than expected, but leaving long rates trading in a range. Growth would slow and unemployment would rise, and while credit defaults would remain low for the time being, a decline in corporate earnings would lead to weakness in equities. Finally, in the shadow of the recent flash crash in U.K. gilts, we warned that the lagging impact of tighter policy would raise the risk of accidents and breakages in the system.

So far, our macroeconomic outlook has been correct aside from the stronger-than-expected jobs market. Yet equities did not struggle—the MSCI All Country World Index was up almost 10% by the end of January and remains up around 3% for the year.

Disaggregating the performance helps to clarify things. Particularly since mid-February, a lot of it has come from a handful of U.S. mega-cap technology stocks. The rest of the global equity market has been fairly flat.

Now, we did anticipate the possibility of this kind of rotation three months ago, when we noted the potential for re-leveraging by algorithmic trading programs, short covering and tactical buying of the big losing sectors from 2022. But has there been more to it? And was it linked to our warning about the disruptive effects of tighter policy?

Perilous

As Brad Tank wrote last week, the sudden eruption of uncertainty in the banking system is both a signal that monetary policy has tightened financial conditions significantly and a likely driver of further tightening.

That may persuade central banks that they are “at or near their objectives,” inducing a pause or even a peak in this cycle’s rate hikes, especially if there are more banking casualties to come.

If the equity market sensed this fragility all along, perhaps that is why it rotated back into mega-cap tech. Have investors been positioning for a substantial hit to financial conditions and economic growth, and a subsequent policy pivot—even a return to the winners from the negative real rates and quantitative easing of the period following the Global Financial Crisis?

We think it may be perilous to get sucked into this narrative. At a stretch, the U.S. Federal Reserve’s new Bank Term Funding Program could be characterized as “QE-lite.” In reality, while the cycle may be turning, we do not think it’s “re-turning” us to the pre-COVID world.

That world of low inflation, low rates and low-but-steady growth, which favored longer-duration assets like big-cap tech stocks and U.S. Treasuries, is gone. Our world is one of stickier and structurally higher inflation and central banks that lean hawkish rather than dovish.

As such, we believe caution on equities remains warranted, especially when higher yields on cash and short-duration assets make the opportunity costs low. After all, if the cycle is turning, it’s because financial conditions continue to tighten, growth is slowing and uncertainty stalks the banking system.

Opportunities

That said, when a cycle turns, caution should not mean inactivity.

In public markets, we believe the time is right for investors to start identifying the equity valuation and credit-spread levels where they would be comfortable adding risk, with a view to easing from a defensive to a neutral stance as the cycle turns. As they do so, we believe a structural bias to value, quality, and regional and size diversification is more likely to suit the next cycle than the old bias to U.S. large-cap growth.

In private markets, particularly markets for private credit and specialist capital solutions, we would go further. We think now is the time to deploy capital. Traditional lenders were tightening standards even before the latest banking concerns. Many are now withdrawing altogether, leaving behind a growing opportunity set of attractive yields and lender-friendly terms for investors.

In November’s Solving for 2023 outlook, our leading idea was that this year would see a peak in rates and inflation and a trough in growth, beginning a new cycle characterized by an “old normal” of structurally higher nominal and real rates. Recent events appear to have brought the turning point closer, and we think investors should be ready to respond.

On April 18, Erik Knutzen will be joined by a guest from the AAC to discuss the Committee’s views in more detail. Register here.

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