Global Macro: A Nimble Strategy for Ongoing Volatility
Michael Dicks discusses the investment strategy of the PGIM Wadhwani Keynes Systematic Absolute Return Fund
Following the bloodletting witnessed during the first half of 2022, global equity markets tried to stage a rebound in the third quarter. Stocks were strong out of the gate early in the quarter but gave back most of these gains since mid-August as central bank rhetoric turned more hawkish and inflation did not deliver the declines investors had hoped for. Most major markets outside the U.S. have fallen, especially in U.S. dollar terms, on a quarter-to-date basis.
There were few places to hide in the first half of 2022 outside of energy and commodity-related assets. With both stocks and bonds down by double-digit percentages, investors experienced significant pain. Government bonds did not play their traditional role of tail-risk hedging assets, with the Bloomberg U.S. Treasury Index falling 9.1% during the first half—the worst six-month return on record going back to 1973.
Tighter monetary policy works primarily by tightening financial conditions, and the Fed is happy to see this occurring at present. Any relief rallies in the current environment may be self-limiting as substantially looser financial conditions could drive central banks to lift rates even higher. However, we believe we may be approaching the point of peak central bank hawkishness.
This environment argues for maintaining cautious tactical positioning, at least in the near term or until there is more clarity on the inflation front. Further, the likelihood of a global recession underscores the threat of even higher risk premia (and associated declines) across risky assets. While equity markets have already experienced the type of drawdowns that may be expected amid a mild recession, still-larger declines are a real possibility. Other asset classes, like U.S. high yield bonds, are not yet pricing in a recession outcome and would be at greater valuation risk if/when the recession arrives.
We do not think the U.S. economy will navigate the current tightening cycle without experiencing a recession. Soft landings are rare to begin with and are the exception, not the rule, following Fed tightening cycles. There have been 14 Fed hiking cycles in the U.S. since 1950 and 11 of them led to a recession.1 Historically, a soft landing has never been achieved with headline and core CPI inflation rates running at current levels and with the unemployment rate near a record low, as it is today. Nevertheless, while a U.S. recession may be on the horizon, it does not yet look imminent.
U.S. growth and small-cap stocks rebounded, reversing some of their year-to-date underperformance versus the broad U.S. equity market, which also posted modest gains. Meanwhile, EAFE and emerging market stocks maintained declines.
Developed countries like the U.K., Germany, Japan, Canada, and Italy are trading in their cheapest decile of forward P/E ratios in 20 years. Interest rates in these countries have played a role in valuation compression, as have earnings growth expectations, but these markets are trading at what appear to be bargain-basement prices. U.K. and German equities are trading at single-digit multiples of 9.1 and 9.5, respectively. Emerging market equities are also attractively valued, most notably in Latin America, which is currently trading at a forward multiple of 7.3 times earnings, the cheapest percentile of its 20-year history.
The U.S. equity market has also seen valuation ratios improve, but it remains the most expensive developed market. The forward P/E ratio in the U.S. has fallen from its post-COVID high of 23.4 to 17 as of the end of August. This ratio is roughly in line with its 10-year average but is in the 68th percentile of its 20-year average, so still expensive on an absolute basis relative to history. However, even in the U.S. there are pockets of attractive valuation, including value stocks, small caps, energy, and financials (especially banks).
Capitalization (cap) rates in private real estate have stayed fairly steady and at historically low levels (valuation here is appraisal based and value adjustments significantly lag the real-time pricing of publicly traded markets), while bond yields have seen significant upward adjustment. Commercial real estate is even more overvalued than it was pre-Global Financial Crisis. Our colleagues at PGIM Real Estate expect commercial real estate prices to fall 10-15% over the next few years in order for value to be restored in these markets. In a risk scenario where the 10-year Treasury yield reaches 4-5% and stays there for an extended period, price declines could be roughly double the base-case amount. Publicly traded real estate investment trusts (REITs) have either fully or partially discounted these declines, depending on which scenario prevails with the S&P U.S. REIT Index, falling roughly 26% year to date through 9/21/2022.
We continue to expect long-term secular forces to support commodity prices and returns. The path to green energy technology will need to be paved with continued use of fossil fuels, and the investment in production has lagged the demand for close to a decade. Short-term forecasting of commodity prices is notoriously tricky, doubly so in the face of a global monetary tightening cycle and the unknown impact on demand. Commodities are at risk of a significant drawdown in the event of global recession. However, we remain confident in the medium- to long-term probability that commodity prices will exhibit an upward bias to clear the expected supply-and-demand imbalance. Financial flows are likely to exacerbate the deficits in the physical markets as investors seek inexpensive inflation hedges such as commodities.
1Source: Federal Reserve, Rosenberg Research
Bloomberg U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Indices are unmanaged and are provided for informational purposes only. Investors cannot directly invest in an index. The MSCI EAFE Index is an equity index which captures large- and mid-cap representation across 21 Developed Markets countries around the world, excluding the U.S. and Canada. The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
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