The ‘real regime’ during the equity correction
■ Since the start of the year, a combination of hawkish monetary policy, the war in Ukraine and the risks from China zero-COVID policies have dragged markets in a ‘Balanced Bear’, with equities selling off alongside bonds.
■ With a worsening growth/inﬂation mix, inﬂation expectations have decorrelated from growth pricing, leading to an important regime shift: while for most of the last cycle and the post-COVID 19 recovery, equities have been positively correlated with inﬂation expectations, the correlation has turned less positive recently.
■ As we think the inﬂation/growth gaps that have built up both at a macro and markets level should eventually close, we revisit our ‘Real Regime’ framework. With real rates likely to continue to move higher from here according to our strategists, the implications for cross-asset performance will vary materially depending on the pricing of growth.
■ While cyclicals vs. defensives already price a decent amount of slowdown in activity data, the low conviction level across investors and the likely continuation of the negative growth momentum might mean the equity market is yet to reach the trough in cyclical pricing. On expectations of lower risk-adjusted returns near term until the market fades both growth and inﬂation risks, we recently downgraded equity to neutral in our asset allocation (over 3m) and think the Dollar, alongside our OW cash, can continue to be the best hedge. We believe value exposed sectors can also continue to outperform growth and help manage portfolio duration, while elevated levels of inﬂation can further support real assets.
Since the start of the year and in particular since the end of March, equities have suffered from a hawkish monetary policy pivot driven by inﬂationary pressures in the post-pandemic recovery. The start of the war in Ukraine in late February and China zero-COVID policies have not only added pressures on inﬂation but have also triggered growth concerns across investors. The equity correction has resulted in a ‘Balanced Bear’, i.e. a large drawdown for balanced portfolios, with bonds selling off alongside equities. As we wrote in our Balanced Bear Despair research, as inﬂation and hawkish policy become the key drivers of rates rather than growth, equities struggle to digest higher bond yields, leaving balanced and standard 60/40 portfolios in a tough spot.
Comparing the price action across assets during the sell-off to the performance implied by each asset’s historical beta to the S&P 500 shows that, with inﬂation being the main market driver so far, commodities and bonds have reversed their typical relationship to equities (Exhibit 1). As we wrote in Balanced Bear Despair – Part 3, allocations to shorter-duration and real assets can improve the risk/reward of balanced portfolios in periods of high inﬂation. In fact, commodities, value and infrastructure have materially outperformed their beta to equities, offering good diversiﬁcation opportunities for multi-asset investors, while bonds have exacerbated the losses.
In the past we showed that equities can perform well even with rising rates, provided the increase is gradual and accompanied by better growth expectations; this has not been the case over the past months – the 12m rolling equity/bond yield correlation has been less positive and is now close to zero (Exhibit 2). Certainly, the speed of the bond sell-off, the elevated rates volatility and real rates taking the lead in the move have all contributed to the indigestion in the equity market, but dissecting the equity/bond correlation into its drivers (i.e. real yields and breakeven inﬂation) reveals an important regime shift: while for most of the last cycle and the post-COVID 19 recovery equities have been positively correlated with inﬂation expectations, the correlation has turned less positive recently.
We think the correlation break between equities and inﬂation expectations is linked to the worsening growth/inﬂation mix YTD: With inﬂation being higher and stickier than previously expected, the risks of negative feedback loops to growth have increased. In fact, 1-year ahead consensus data show a large decoupling of growth and inﬂation expectations (Exhibit 3). This points to growing risks of stagﬂation, in particular with central banks tightening ﬁnancial conditions to get inﬂation under control, potentially at the expense of growth (and risky assets).
This divergence at the macroeconomic level has resulted in breakevens being less clearly linked to growth as captured by cyclical vs. defensive equities. Historically, US 10-year breakevens have been very positively correlated to cyclical vs. defensive only since 2010. Over this period growth and inﬂation expectations have also been more positively correlated – after the global ﬁnancial crisis, secular stagnation fears were accompanied by deﬂationary pressures. However, that has not always been the case: Exhibit 4 shows that from the 1970s to the late 1990s, the relationship between breakevens and cyclicals vs. defensives was weak. With this in mind, the recent decrease in correlation is not surprising and it is actually consistent with higher inﬂation being accompanied by fears that the Fed’s (and global central banks’ more broadly) ﬁght against inﬂation will eventually lead to a slowdown in growth.
We think the growth/inﬂation and the breakeven inﬂation/cyclicals vs. defensives gaps should eventually close, with markets increasingly focusing on growth and inﬂation peaking. As the dynamic and speed of the adjustment will be particularly relevant for cross-asset performance, we ﬁnd it useful to revisit our ‘Real Regime‘ framework. In the past we found that the interplay between breakevens and real rates provided a good proxy for the growth/policy regime. While real rates continue to closely reﬂect monetary policy, we think replacing breakevens with the performance of cyclicals vs. defensives is currently more appropriate and allows us to extend the analysis further back in time. On expectations of inﬂation likely peaking in the US and further monetary policy tightening, our strategists believe real rates will continue to move higher from here. As Exhibit 5 shows, this can have very different implications for cross-asset performance depending on whether growth will be repriced lower or not, with the former potentially adding further pressure to equities near term .
Cyclicals vs. defensives already price a decent amount of slowdown in activity data, especially in Europe, but they are not fully priced in for a recession. While our economists do not envision a recession in the US in their base case (especially not a deep one), the low conviction level across investors and the likely continuation of the negative growth momentum might mean the equity market is yet to reach the trough in cyclical pricing. Excluding very short cycles such as the Covid-19 shock, cyclicals vs. defensives have generally troughed at least after three months of weak activity data and eight on average (ex. GFC) – thus growth pricing might remain under pressure. A cross-asset screen of upside and downside sensitivities to real rates and equity growth pricing respectively shows that the Dollar, alongside our OW cash, could continue to be the best hedge until the market convincingly fades growth risks (Exhibit 6). Value exposed sectors could also continue to outperform growth and help manage portfolio duration, while elevated levels of inﬂation could further support real assets. JPY screens instead as the most effective FX hedge against a recession shock given the asymmetry created by its valuation against USD. In our recent asset allocation update, we remain modestly pro-risk for 12m but expect risky assets to remain stuck in their ‘fat and ﬂat’ range near-term until the growth/inﬂation mix improves. We therefore downgraded equities to neutral for 3m (remain OW for 12m), while remaining OW cash & commodities and UW credit & sovereign bonds (both 3m and 12m).