Markets Weekly podcast – 15 May 2023

Henk Potts (HP): Hello. It’s Monday, 15th May and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets. 

My name is Henk Potts, Market Strategist with Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors. 

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider some principles around long-term investment. And, finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Investors have been in a holding pattern as they await the answers to some crucial macro questions, including how much damage will the banking crisis and debt ceiling stalemate cause? Is inflation moderating quickly enough to conclude the hiking cycle? And how aggressive will the slowdown be in advanced economies over the course of the coming quarters?

The lack of clarity has kept equities trading in a tight range and led to some lower levels of volatility.

Last week, markets were bombarded by a range of conflicting messages, as US CPI moderated, the UK economy managed to avoid a recession, but traders continued to be unnerved by the political impasse of delaying a resolution on the debt ceiling and mixed recovery data emerging from China, where inflation, imports and credit growth were all weak in April.

We also had some hawkish statements coming through from the European Central Bank and, to a certain extent, the Monetary Policy Committee, and an unexpected acceleration in US consumer long-term inflation expectations and a fall in confidence levels.

In terms of performance, the STOXX 600 in Europe was flat over the course of the week, remained 0.9% below its 52-week high that was hit on 18th April. The S&P 500 was down 0.3% during the course of last week.

Confirmation that US price pressures are slowly moderating did help risk sentiment. Headline CPI rose 0.37% month-on-month and 4.9% year-on-year in April. That compares to 5% in March. Core consumer prices rose four-tenths of 1%, the annual rate ticked down to 5.5%

In terms of the breakdown of the report, well, core goods prices rose more than expected, helped by a robust increase in used-car prices, which was partially offset by declining prices for air fares, hotels and new cars. Shelter costs, which, remember, make up around a third of the consumer price index, rose four-tenths of 1% last month. That is the smallest increase that we’ve seen in a year. 

It’s certainly seen as a positive as the expectation was that housing, which is a lagging indicator, would take longer to moderate. Most importantly, annual inflation in the US has now moderated for 10 consecutive months. CPI is back below 5% for the first time in two years and that compares to a peak of 9.1% in June 2022.

In terms of the outlook for inflation, we expect that moderation trend to continue, with US CPI set to print at 2.5% by the time we get to December of this year. 

The easing of price pressures, early signs the US labour market is starting to cool and the impact of tightening of financial conditions in the US, caused by the banking crisis and the previous rate increases, certainly seems enough to justify the pause in the signal that was offered by the FOMC, at the May meeting.

In terms of the UK, well, investors had to digest the first-quarter GDP data and the latest Bank of England interest rate decision. The UK economy defied dire predictions at the start of the year by growing in Q1, where the expansion in activity was a meagre 0.1% and gross domestic product fell three-tenths of 1% in March.

Services had a poor month, down half of 1%, while industrial production and construction both registered gains.

Demand for services may have been temporarily impacted by the poor weather and industrial action, but some broader-based weakening has clearly been taking place. Elevated levels of inflation and higher mortgage rates are eroding household real disposable incomes and constraining consumption.

Private consumption was flat in the first quarter and retail sales volumes declined nine-tenths of 1% in March. We expect UK consumption growth to remain very weak. In fact, averaging just 0.2% during the course of this year and 0.3% in 2024. That compares to that 5.6% increase that was recorded in 2022.

In terms of the outlook for the UK economy, well UK growth prospects have been supported by resilient global growth, lower energy prices and the fiscal support capital allowances for business investment that was offered in the spring budget.

However, there is no escaping the impact of the aggressive rate hikes, the multitude of pressures on consumers and the medium-term fiscal tightening. We expect the UK economy to flatline during the course of this year, and then deliver a very tepid recovery in 2024, with real GDP rising just four-tenths of 1%.

In terms of policy, well, as expected, the MPC hiked rates by 25 basis points. It’s now raised rates 12 consecutive meetings, pushing its benchmark lending rate up from 0.1% in December 2021 to 4.5% in May, its highest since 2008.

At the meeting, policymakers left guidance on the future path of interest rates unchanged, keeping their options open, reiterating that evidence of persistent inflationary pressures, as determined by the evolution of labour markets, wage growth and services inflation could require further tightening.

In terms of the outlook for policy, we believe the upgraded inflation profile and the more upbeat assessment of activity is enough to convince the MPC to push ahead with one final 25-basis point hike at the June meeting, making the terminal rate 4.75% for this cycle.

Beyond June, with rates in deeply restrictive territory and moderating inflation and the impact of previous rate increases starting to hit the real economy, that should be sufficient enough to encourage policymakers, we think, to keep rates on hold until well into 2024. 

We do see the potential for rate cuts next year, but don’t believe they’ll occur until late summer. Starting at the August meeting next year, we project that the MPC will embark upon a series of 25-basis point reductions, leaving the bank rate at 3.75% at the end of 2024.

So, that was the global economy and financial markets last week. We’re now going to escape the short-term melees of the markets as I’m joined by Nikola Vasiljevic and Lukas Gehrig from the Quantitative Strategy team at Barclays Private Bank. Nikola and Lukas are tasked with generating risk and return estimates for the long-term investment process. 

Gentlemen, great to have you join us today. Lukas, let’s start with you. When generating capital market assumptions, do you look five to maybe even 10 years ahead, so the timing of the next hike becomes somewhat negligible? How do you tackle such a time horizon from a macroeconomic perspective?

Lukas Gehrig (LG): Well, Henk, when you lengthen your forecast horizon to five or 10 or even 15 years, structural anchors really take centre stage in your projection. So, take, for example, economic growth. You would usually consider labour input, capital input and productivity, which kind of gels these two inputs together to produce your structural projection.

Now, forecasts for productive capital, they are usually the most boring ones, as there are hardly any big jumps from one year to another. However, the labour side of things has been very interesting over the last decade and they continue to be interesting.

So, let’s take, for example, the UK. Back in 2008 the working-age population of the UK grew by around 1% a year. Nowadays, this growth is only about a quarter percent, and this loss in working-age population, it has been somewhat compensated by increased participation rates over those last 10 years.

So, to give you some numbers, in 2008 every third woman at the age of 60 in the UK was part of the labour force. Nowadays, more than one woman in two, that are of that same age category, are participating in the labour market. 

However, our projections suggest that this boost from the inclusion of older age groups and women will fade. So, going forwards, the UK economy will need another boost, and that boost could come for example from productivity. The ChatGPTs and autonomous vehicles, you name it, they will have to step up and make the remaining workforce more productive.

HP: So, Lukas, I suppose the trillion-dollar question, are we going to experience a recession due to the weight of these structural anchors? And, if at all, when is it finally coming?

LG: Well, Henk, we definitely have an economic slowdown on our charts for growth in developed markets, in some countries even to the point of a recession. But over five years a recession is not as important as is getting the shape of the recession right and of the recovery. And we expect this recovery to be more drawn out and not, as I always like to say, fiscally fast-forwarded, like the COVID-19 recovery was.

In terms of inflation, well, inflation should recede towards central bank target ranges, but remain volatile, as these crucially important inflation expectation anchors have become loose. In other words, the trust in central banks fulfilling their mandate at all times has definitely decreased.

Lastly, policy rates should glide down towards terminal rates. We estimate them to be a bit above 2% for the Fed, below 2% for the Bank of England and a bit below that for the European Central Bank. That, in turn, means that cash rates will probably not compensate for inflation over a five-year horizon, in both the euro and pound sterling.

HP: Thank you. That really highlights the importance of being and staying invested, and beyond, holding cash. OK. So, looking at markets, how does this macroeconomic backdrop translate into return expectations?

LG: Well, here I find it useful to think in the same building blocks that we use to generate our projections. We decompose returns into income, growth and valuation. So, for fixed income, the income component, which takes the form of yield, is really the most core, important driver. And yields have received a strong boost, which led to our projections of returns of around 4% to 6% for government bonds and up to 8% for high yield.

For equities, well, there’s good and bad news. The good news is that valuations have suffered a lot lately, such that they are now much less of a drag for a long-term forecast than they were before.

The bad news is, obviously, the growth component. With such a projection of anaemic recovery in developed markets, equity returns are really held back. Overall, we still expect annualised returns in equities of between 7% and 8%. 

So, altogether, our expected returns in core assets are really quite decent and this strength is also reflected in our model portfolios, where the core assets have somewhat crowded out cash, commodities or other alternative assets.

HP: Well, thank you, Lukas. Let me now bring in Nikola to get some further insight on the return expectations component. Nikola, the typical 60% equity/40% bonds portfolio, as we know, had a terrible run in 2022. Are we confident there won’t be a repeat in the years to come?

Nikola Vasiljevic (NV): Hi, Henk. Thanks for having us on air today with you, and hello to all the listeners of the podcast.

If we consider historical performance of equities and bonds during any calendar year, 2022 was particularly challenging for 60/40 portfolio investors as equities and bonds fell in tandem, in fact, for the first time since 1973. 

In other words, until recently, government bonds had played the role of reliable safe-haven investments for almost half a century, on average, providing protection during periods of equity market turmoil. When equity/bond correlations shot up last year, amid soaring inflation and surging interest rates, the diversification benefits of bonds eroded quickly. For many investors, this was a painful reminder that the relationship between equity and bond returns holds the key to asset allocation.

So, given this information, clearly, one of the burning questions is what is to be expected in terms of equity/bond correlations, and what might be the potential implications for asset allocation.

Historically, negative equity/bond correlations have survived several macro and bear-market regimes. However, the data shows that it has also varied substantially in the past. The key message here is that macro regimes and uncertainty matter for the long-term performance and co-movement of equities and bonds.

In particular, equities, bonds and inflation corelations tend to move in opposite directions on average. So, for example, during stagflation periods, which are characterised by rising inflation and falling growth, the equity/bond corelation typically flips into the positive territory.

Moreover, both equities and bonds tend to post below-average, or even negative, returns in such a regime and this is precisely what we witnessed last year.

In terms of the outlook, I think it is really important to understand that the equity/bond correlations are particularly elevated during stagflationary periods. Therefore, if we consider a five- or a 10-year investment horizon and the projections presented by Lukas, we expect that the recent macro developments will somewhat weigh on the equity/bond correlations. They will remain elevated relative to the levels seen over the last two decades, for example, but we expect them to be negative on average.

Last, but not least, another important element is that due to macro and geopolitical uncertainty, potential technological shifts and, of course, climate risk that is to stay with us for the long run, we expect that market volatility will be elevated and sticky in the coming years.

HP: OK. So, bearing in mind the thoughts that you’ve made in terms of asset allocation and an imminent slowdown in terms of economic activity, do you believe that this is the time investors should be considering privately traded assets?

NV: It is a great question, Henk. So, historical data shows that private markets have exhibited an elevated illiquidity premium during public market drawdowns. However, it is equally true that illiquid assets tend to lag behind public markets in terms of valuations, simply because they are not marked to market, but rather based on appraisals.

In other words, due to complexity and opacity, all available information is not reflected instantaneously in private-market valuations. For example, in the case of private equity, drawdowns tend to be recorded with a delay of six to 12 months. On top of that, one should not forget that investors in private assets are exposed to significant market and funding liquidity risk during stressed periods.

In terms of market liquidity risk, since secondary private markets are much less developed than their public-market counterparts, liquidating assets relatively quickly and at minimum cost is typically not possible.

Taking, again, the example of private equity, the average discount that sellers in the secondary market have had to accept over the last 20 years was about 13%. Historically, during public-market crashes, the discount was as high as 50% or even more.

The second element, as I mentioned, is the funding liquidity risk, which is associated with the ability and the cost of generating cash in order to meet financial obligations, as they can do. For example, during the great financial crisis, the net cashflow, measured by the difference in capital calls and distributions relative to the unrealised value for Preqin’s broad private-equity index, was about 20%, which, obviously, created a significant pressure in terms of funding liquidity for investors.

All these elements combined tell us that investors are facing a trade-off between a relatively attractive illiquidity premium and elevated market and liquidity risk, at least in the medium term. However, I think that one should see illiquid alternatives in a completely different light from public equities and bonds.

First, these are de facto long-term investments suitable only for patient investors who can tolerate some illiquidity in their portfolios. In turn, they provide an opportunity to boost returns and, additionally, improve diversification.

Moreover, by diversifying investments in private markets across vintages, industries and managers, one can mitigate some of the liquidity risks that I have mentioned before. Therefore, in my view, investments in private assets are truly a long-term story and essentially give us, to a certain extent, the luxury to look beyond shorter investment horizons and focus on fundamentals and the big picture.

HP: Well, thank you to both Lukas and Nikola for sharing your research today. We know that dramatic headlines and daily market movements can be very disturbing for many investors. As we’ve been reminded, it’s really important to step back and consider the long-term approach when considering how to achieve our investment goals.

Let’s move on to the week ahead. This week, the focus will be on US retail sale and industrial production figures on Tuesday. We forecast that US retail sales rose nine-tenths of 1% month-on-month in April, bouncing back from the declines in February and March. The strength of the reading traces almost entirely back to light-vehicle sales, which are reported to have registered a strong increase in April.

Excluding autos, we do not think that sales increases kept pace with prices. Excluding motor-vehicle sales, sales are forecast to have risen just two-tenths of 1% month-on-month.

We think that, overall, US industrial production edged up one-tenth of 1% month-on-month in April, after declining in March. The improvement mainly reflects a 0.4% month-on-month expected gain in the manufacturing component, due to a strong increase in auto assemblies, following months of below-par readings. Excluding motor vehicles, available manufacturing indicators point to a modest 0.1% increase. 

In terms of the UK, markets will await Tuesday’s employment report, where we expect unemployment to have edged slightly lower in the three months to March, to 3.7%. We expect that falling inactivity will be the counterpart to further gains in employment. On wage growth, we expect a 0.5% month-on-month increase, which would translate into a reading of 5.9% year-on-year.

And, with that, I’d like to thank you once again for joining us. I hope that you’ve found this update interesting. We will, of course, be back next week with our next instalment. But, for now, may I wish you every success in the trading week ahead.