Preparing for accelerating slowdown
The prospect of an economic downturn is leading the BNY Mellon Sustainable Global Real Return team to focus on capital preservation in the near term by de-risking the portfolio and bolstering exposure to select areas of alternatives such as renewables.
The team says the resurgence of inflation has reversed the decade-long drift lower in discount rates since the global financial crisis, reducing the price of longer duration assets in both fixed income and equity markets.
“These developments look set to cause a marked slowdown in the second half of the year, with many leading indicators already flashing red, and relatively sanguine corporate earnings expectations now looking vulnerable,” the team says.
In the second quarter of 2022 the team made several changes to asset allocation and security selection to boost portfolio defence.
“We have sought to render the portfolio more resilient to a uniquely challenging combination of factors that are evolving rapidly, and increasingly look set to precipitate an economic downturn as we move into the second half of the year,” the team says.
Despite the short-term rally in equity markets since the end of the quarter, which the team attributes more to technical and seasonal factors rather than any fundamental improvement in the economic outlook, the cautious view remains unchanged.
This risk-off mindset led to a reduction in net equity exposure through an increase in direct equity market protection and changes to the underlying equity portfolio. As at 31 July 2022, the net equity exposure stood at 15.8% of the portfolio, down marginally from 15.9% in June 2022, and down from 21.7% in May 2022.
In terms of protection, the team expanded the scale of the strategy’s short futures positions on the S&P 500 and Eurostoxx 50 indices. Meanwhile, exposure to growth stocks was reduced in the underlying equities portfolio through the sale of Alphabet, Amazon and Elanco, as well as a reduction in long-standing holding, Microsoft.
Elsewhere, cyclical exposure was pared back on the expectation of higher prices affecting consumers and corporate profit margins, with the position in Volkswagen sold and the position in US railroad operator Norfolk Southern reduced during the quarter.
The team put some of the proceeds of these movements into cash but also added to certain defensive names, including Unilever and select healthcare names.
Cash was also raised through a reduction in the copper exchange trade fund (ETF) position on account of the team’s near-term macroeconomic concerns outweighing the encouraging medium-term supply/demand dynamics.
Some cash was used to purchase two-year government debt which the team said offered an attractive yield and a decent pickup on cash rates, following the recent spate of interest rate rises.
“In contrast to the historical experience over the careers of most of today’s established investors, longer-dated government bonds have not worked as a hedge for risk assets on this occasion; however, as inflation eases, we are likely to see the traditional negative correlation with risk assets reassert itself and this asset class could once again become a more valuable part of our toolkit.”
In the coming quarters, the team is looking at assets underpinned by secure, and in some cases index-linked, income streams within alternatives in areas such as renewables and infrastructure. As at 31 July 2022, the portfolio had a 23.9% weighting in alternatives, up from 16.8% at the end of July 2021 and 13.7% at the end of July 2020.
“We favour alternatives because they provide diversification, income and inflation protection. Alternatives, particularly our renewables positions, has been a larger portion of the portfolio this year.”
The team also notes recent market tumult is starting to surface interesting opportunities in more esoteric areas. For instance, at the end of the quarter, it participated in an additional tier 1 (AT1) bank debt (contingent convertible bond) issue from Barclays.
Looking ahead, the team thinks inflation looks set to moderate given the mechanics of its calculation and the impact of the demand destruction being experienced in many areas.
“In many ways, the key dynamic for markets in the coming months could be how quickly this transpires, therefore giving the US Federal Reserve and other central banks space to pivot to a more accommodative stance, relative to the pace at which the economic slowdown materialises.”
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1084362 Exp: 21 November 2022