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Annual Best Ideas

Macro Uncertainty Calls for Agility & DiversificationMacroUncertaintyCallsforAgility&Diversification

Jan 19, 2023

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Global markets took a beating during most of 2022. Lingering supply chain issues, exacerbated by the war in Ukraine and pandemic-induced shutdowns in China, helped push global inflation significantly higher. As central banks tightened monetary policy in response, fears of recession gripped markets, with stocks, bonds and real estate assets declining sharply throughout most of the year. Meanwhile, commodities generally rallied, although returns were somewhat divergent.

With central banks around the world enacting restrictive monetary policies to rein in inflation, we have highlighted four macroeconomic scenarios most likely to occur depending on future moves of the US Federal Reserve:

1. A “soft landing”: The Fed’s forecasts turn out to be broadly correct, with inflation gradually dropping back to target, but without unemployment rising substantially, and with a recession being avoided.

2. Persistent inflation & recession: Inflation turns out to be more stubborn than expected and the Fed is forced to tighten by more than is priced in and/or keep rates high for longer, thereby eventually precipitating a recession, perhaps in the second half of 2023.

3. The Fed tolerates higher inflation: The Fed tightens to bring inflation down from current levels but is unwilling to take risks with respect to a recession or financial stability, and so pauses before it has done enough to bring inflation down back to target. This might postpone a recession into 2024.

4. A “hard landing”: The tightening in financial conditions that has already come about leads to a recession, and perhaps quite quickly (in the first half of 2023), and thus the Fed may end up tightening less than is currently priced in.

For much of 2022, investor expectations generally aligned with a greater likelihood of scenario two transpiring—i.e., persistent inflation followed by recession—in part because the extent of the rise in unemployment projected by the Fed had been associated with past recessions.

As other central banks signaled or slowed the pace of rate increases late in the year, investors turned bullish, anticipating that the Fed, too, would move to a less aggressive stance. Amid this backdrop, the probability of either a soft landing (scenario one) or the possibility that the Fed might be willing to implicitly accept a higher inflation target (scenario three) increased, and along with it, equity markets partially recovered prior losses. With the ECB and Fed sounding hawkish in December, investors might revisit their bullish stance.

Global Macro Outshines Amid Market Chaos

Source: Morningstar Direct, PGIM Quantitative Solutions as of 10/31/2022. Global macro represented by Societe Generale Macro Trading Quant Index, bonds represented by Bloomberg Global Aggregate Index, 60/40 represented by 60% S&P 500 and 40% Bloomberg U.S. Aggregate Bond Index, real estate represented by FTSE EPRA NAREIT Global Index, stocks represented by MSCI All Country World Index. Past performance does not guarantee future results.

An especially strong tactical case can be made to increase exposure to liquid alternatives under current conditions.

Agile Diversification Remains A Priority

With headline inflation likely to have peaked (or to peak soon) in many countries, and central banks tightening at a slower pace, investor hopes of a “soft landing” in the US are likely to rise. On the other hand, a slowing global economy is likely to put downward pressure on earnings forecasts. The outlook for equity markets is therefore uncertain. As noted above, there are concerns that central banks might implicitly tolerate a higher rate of inflation, and this could undermine bonds.

It is therefore possible that the traditional 60/40 portfolio mode may continue to fare poorly. An agile global macro strategy can isolate diverse and less correlated sources of returns by factoring in regime shifts and profound changes in sentiment or expectations. The ability to go both long and short in various asset classes is an additional advantage, providing flexibility to react nimbly as conditions shift. Global macro delivered strong absolute returns and relative returns versus stocks, bonds and real estate this last year, making it an attractive portfolio diversifier and alternate return source through rising rates and inflation.

Traditional investors typically hold bonds as a hedge against their long equities positions. In some ways they stand to get hit twice if markets experience elements of stagflation. Consequently, strategies that hedge against tail risks, such as those that rely on identifying down trends in equity and fixed income markets and take advantage of these by shorting those assets, have shown themselves able to perform well when both equities and bonds are declining.

Liquid alternatives aim to provide uncorrelated sources of return from traditional long-only stock and bond approaches by employing shorting strategies to capitalize on falling prices and casting a wider net through investing in other asset classes. While liquid alternatives are typically a good strategic allocation for investors in any environment, an especially strong tactical case can be made to increase exposure to liquid alternatives under current conditions.

No investor is able to predict exactly when the next episode of sustained equity weakness will occur, so having some allocation to a macro tail-risk strategy can be prudent even in what appears to be “good times.” Tail-risk strategies extract sources of returns from different underlying asset classes, giving them a diversifying aspect, as well as a hedging feature. We believe it’s important to have such an allocation as it can change as the world changes, and that flexibility is what enables tail-risk protection at both the point of shock and on an ongoing basis.

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