Market Uncertainty Calls for Doubling Down on Diversification
Jun 14, 2023
Debt ceiling negotiations in the U.S. are an additional concern that could help precipitate a recession.
The recent bout of financial instability set off by the collapse of Silicon Valley Bank seems to have been allayed by the Federal Reserve’s swift contagion-limiting actions, with stock markets steadying yet pricing in a somewhat higher probability of an eventual recession in the U.S. Fixed income markets, too, appear to reflect more confidence in a recession and/or lower inflation. Debt ceiling negotiations in the U.S. are an additional concern that could help precipitate a recession.
Inflation is slowing and is likely to be substantially lower this year compared to 2022. Nevertheless, wage inflation remains elevated at rates that don’t align with the Fed’s 2% inflation target. Add to that the financial sector difficulties and inflation could be allowed to stay higher for some time if central banks put the brakes on interest rate hikes to ensure financial sector stability. And in the longer run, rising “green” investment and higher defense spending following Russia’s aggression suggest that inflation is likely to be higher over the next 10 years than it has in the last 10.
As market volatility and concerns about interest rates and inflation transform into recession concerns, we feel there are three plausible scenarios for the U.S. economy that we judge each warrant having a significant probability attached to them, depending upon both the macro-economic outcome and policymakers’ reaction to it:
- A “soft landing” – The Fed likely pauses following its May 25bp rate hike and inflation gets back to target without a recession. The Fed can then cut rates after some time to take them back toward the assumed neutral rate of 2.5% - 3%. Equity markets may have significant further upside if this scenario comes about, as earnings forecasts would likely move higher and actual short-term rates go lower.
- “No landing” – Assuming that the banking sector turbulence settles down, and there are no other significant shocks, it is possible that wage growth and services inflation remain too high. Therefore, even if the Fed pauses after its May meeting tightening may resume later in 2023 sending short-dated bonds lower. This scenario is likely a temporary situation that either eventuates in a “soft landing” or a “hard landing.” The impact on equities is uncertain in the short run as it depends on if markets believe the eventual destination is a “soft landing” or not, which may not be evident until sometime in 2024.
- A (quick) “hard landing” – In some past recessions, the economy appeared resilient, but then suddenly crumbled (as it did between October - December 2000, or after a financial event). It is possible that banking sector woes persist, or build further, and that this proves to be the catalyst for a quick hard landing. Alternatively, the current debt limit standoff could trigger fiscal tightening and/or a fall in consumer confidence and thereby precipitate a recession. In this scenario, earnings forecasts would have to move lower very quickly, taking equities with them, but bonds would do well.
Given the three scenarios, what are the asset class implications one could expect? We believe the possibilities are as follows:
*Note that the short-term impact on short-dated fixed income would be for them to fall, as it becomes evident that the Fed has to work harder than is priced in. Where other asset prices end up will depend upon whether the markets believe the eventual destination is a soft landing or a hard one.
WHERE TO HIDE AMID MARKET TURMOIL?
Above we discuss the possibility of a “quick” recession caused by financial stress. Historically, this type of recession has been painful for equities, so while sovereign bonds typically held up well, 60/40 portfolios struggled. But there’s the possibility of a different scenario: Fed tightening is paused for a time, but inflation remains too high for comfort, and the Fed therefore resumes interest rate hikes, eventually leading to a recession. This recession scenario, where inflation surprises positively on the upside, is very bad for a 60/40 portfolio because both equities and bonds decline. We saw this in 2022 and in prior periods of high inflation, like the 1970s.
The added diversification of liquid alternatives has historically benefited investors, as trend following and macro strategies have tended to do well in both recession scenarios described, as compared to a 60/40 portfolio. Over the last 50 years, trend following has outperformed the 10 worst periods for 60/40 portfolios. So, for example, a 60/40 portfolio was down more than 15% in 2022, while a trend following portfolio was up more than 15%.
MANAGED FUTURES TEND TO OUTPERFORM A 60/40 PORTFOLIO DURING NBER DEFINED RECESSIONS
The bar graph displays the 60/40 and Managed Futures performance, based on monthly returns, during the worst 1-year losses in 60/40 portfolios. We calculate returns for a 60/40 portfolio to represent the returns on a traditional, long-only portfolio. When constructing returns of a 60/40 portfolio, the MSCI Total Returns Index for the U.S. was used to calculate for equities, while the Barclays U.S. Treasury Bond Index was used to calculate for bonds. For illustrative purposes only. Does not constitute investment advice and should not be used as the basis for any investment decision. There is no current PGIM Wadhwani client portfolio with this composition of assets.
But what if a recession doesn’t materialize and instead, we get a soft landing? Liquid alts strategies are very adaptable and can adjust as the probability of a soft-landing increases. In such a scenario, they may not do as well as a 60/40 portfolio but are still likely to deliver a positive return. Liquid alts can be thought of as a form of relatively costless insurance: providing protection when a 60/40 portfolio does poorly, but still generating positive returns when a 60/40 portfolio does well. And it’s important to remember that times of outperformance for 60/40 portfolios often represent attractive entry points for liquid alts strategies – a sort of “two steps forward, one step back.” We’ve noted that 2023 might represent a low point in headline inflation, with inflation rising again in 2024 and 2025. If that turns out to be the case, it won’t be surprising if a 60/40 portfolio does poorly again, and liquid alts outperform.
TWO STEPS FORWARD, ONE STEP BACK
The line displays Managed Futures performance, based on monthly returns. For details of how the returns of CTAs were calculated, please see the disclosure section below. For illustrative purposes only. Does not constitute investment advice and should not be used as the basis for any investment decision. There is no current PGIM Wadhwani client portfolio with this composition of assets.
CONCLUSION
We think that, on average, investors are still not diversified enough in their portfolios, with most relying quite heavily on 60/40 strategies and allocating too little to systematic macro strategies, which have a very low correlation with conventional assets. In the current environment where there is significant recession risk, these strategies can be especially valuable. But even if a full-blown recession doesn’t materialize, managed futures have the potential to make money and protect portfolios. We believe that the last stages of a tightening cycle, financial fragility, and a potential recession could generate significant opportunity for managed futures strategies for the balance of 2023 and beyond.
For managed future (CTA) returns, we have constructed a synthetic index based on the DJ CS Managed Futures Index (from 1994 onwards); the CISDM CTA Asset Weighted Index (from 1980 to 1993); and, in order to go back before 1979, the Campbell and Company Composite Index.
These series are spliced together so as to provide returns data back to the 1970s.
For the purposes of making the CISDM and Campbell returns indices comparable with the Credit Suisse returns data, we have used regression coefficients based on their overlap periods. Wherever possible, we used monthly data. However, the Campbell and Company Composite Index is only available on a quarterly basis.
The U.S. Business Cycle Expansions and Contractions NBER data is taken from: https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions
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The views expressed herein are those of PGIM Wadhwani investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute an offer to sell or a solicitation to buy any security.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
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