There are some fund managers who often dismiss considering macroeconomic factors when making investments in favour of sticking to purely the bottom-up fundamentals.
In the long run, staying invested has panned out well for most equity market investors but even so, Ruffer’s Duncan MacInnes has warned that investors who choose to ignore the risks of major macroeconomic events do so at their own peril, especially in today’s environment.
One reason the manager of the Ruffer Investment Company is so conscious of macro risks is due to his formative experiences during the 2008 Global Financial Crisis after joining Barclays two weeks before Lehman Brothers went bust.
“That was my first job and so I sort of experienced the financial crisis first-hand, but I was so young and naive and green that I had no real idea what was happening – but I was close enough and smart enough to realise that no one else had a clue,” he said.
“Watching everyone get just wiped out – sideswiped – by a major macro event like that made me forever think: ‘well, you can’t just ignore macro’.
“Fair enough nine years out of 10 you probably can, but once a decade it will destroy you.”
Performance of the MSCI World index amidst the GFC
Source: FE Analytics
For the past decade or longer, investors have had the luxury of low and benign inflation coupled with declining interest rates. But now that inflation is high and sticky, central banks are in a tight spot – and the most obvious action they can take is raising interest rates.
“Most don’t understand how the Fed raising interest rates literally changes everything,” MacInnes said. “It ripples out to everything, because everything is a duration asset to some degree.”
But this is something that the conventional fund management industry has yet to fully understand, according to MacInnes.
Whilst the industry is well-aware of the problems with long-duration bonds yielding little to no interest in an environment of high inflation, they have been pushed away from conventional bonds into high yield bonds, infrastructure, renewables and other alternative assets in a search for yield.
“I think they don't realise that those are still very long duration,” MacInnes said. “If interest rates go up by 1%, the NAV of those assets should fall by 20% to 25%, and that hasn't really happened yet.”
He quoted former US Federal Reserve governor Kevin Wash who once said: ‘raising interest rates gets in all the cracks’.
“The cracks are private equity, venture capital, infrastructure, renewables equities, high yield… its everything,” MacInnes explained.
“That's why we're pretty concerned about the market this year because the Fed seems absolutely determined to raise interest rates and to withdraw liquidity to shrink the balance sheet.
“You can try the macroprudential stuff, but when you raise interest rates, it just affects everything.”
Macroprudential regulation is a regulatory approach by policymakers to mitigate systemic risk to the financial system, an approach that arose in the aftermath of the 2008 crisis.
Despite this being the consensus approach amongst central bankers, MacInnes is expecting that the Federal Reserve will be forced to hike interest rates “until something breaks”.
He said: “Fed governor Jim Bullard was saying they need to get interest rates back to positive in real terms, which obviously today would be like 8% interest rates. I assure you something will have broken before they get to 8%.
“Every single Fed hiking cycle in history has ended in a market crash or recession or both. Ultimately that is because the Fed hikes until something breaks.
“We think that that process is beginning – and we accept there is a possibility that they bottle it and stop – but if inflation is still 6% and they've only got rates to 1.5%, it's very difficult for them to stop because they will be seen to be choosing bailing out Wall Street over Main Street in a midterm election year under a Democratic president.”
But despite this, MacInnes has not ruled out the Fed avoiding raising interest rates enough to combat the level of inflation, and it is what MacInnes described as the “let it rip scenario”.
In this scenario, the Fed lets the economy and inflation boom in the hope that supply chains and energy prices eventually sort themselves out.
In that world, MacInnes expects GDP to stay strong because the economy will be booming, inflation will be strong and investors will want to own value equities, cyclical equities, commodities and gold.
“What would be interesting is whether equity markets actually go up in that scenario,” he said. “We talk about this idea of a benign rotation, sort of like what you've seen so far year-to-date in the S&P 500.”
Performance of S&P 500 growth versus value year-to-date
Source: FE Analytics
MacInnes noted how value stocks have gone up, while growth stocks have fallen, resulting in the overall stock market index not being that badly affected.
He said: “You’ve basically had the long duration tech assets down a lot, but you've had Exxon Mobil and the banks and Berkshire Hathaway up.
“Clearly, that's a far more benign scenario than the nasty rotation. But now we've started this process of wage inflation, and if that gets traction the Fed is in real trouble – and it does seem like it's getting traction.”