Peak interest rates are in sight – Mark Perchtold

After the steep climbs in interest rates, we could finally be approaching the peak. That is according to Mark Perchtold, the founding director of OMBA Advisory and Investments. This perspective comes on the heels of remarks from prominent figures in finance. Bank of England Governor Ben Broadbent said it was an open question whether interest rates in the UK would continue to rise, while Jamie Dimon, the CEO of JP Morgan Chase, issued a stark warning to Wall Street, suggesting that the Federal Reserve might not be finished with its aggressive interest rate hike campaign in the battle against elevated inflation. During an interview with Biznews, Perchtold said, fortunately, inflation is trending downward, which could pave the way for central banks to announce rate cuts in the future. However, he cautioned that on the flip side of the coin, such rate cuts could potentially trigger a recession in developed countries. Despite ongoing geopolitical tensions, Perchtold remains bullish on China. China, he said, trades cheaply, and the bad news has been priced in.“They have stopped making big policy changes and are supportive of platform business,” he says. One of the changes that OMBA has made to its portfolios is moving some of its S&P 500 allocation into S&P 500 Equal Weight.Linda van Tilburg

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Excerpts from the Interview

US Interest Rates Nearing Peak, Possible 25-50 Basis Point Increase Ahead

It’s a never-ending question or it feels like it over the last two years: Where will the Fed land up on interest rates? Without being too prescriptive as economic data changes and as the world changes, one has to change that view. It does, in our view, seem like we’re getting close to peak rates. Perhaps the Federal Reserve needs to move another 25 or 50 basis, which I think would be a surprise to markets. That’s not fully priced in at the moment. We’ve come a long way from 0 to 25 range in interest rates and the pass-through of that into the economy is slowly starting to take place in some areas of the market in terms of companies that are overleveraged or households which are overleveraged. The reality is that in the US the labour market is still very strong and we saw job openings surprise to the upside, which then caused further jitters in bond markets as I think the Fed rates are likely to stay higher for longer. Whether they hike Fed Funds rates more is a tricky one. I don’t think they need to but they could perhaps hold interest rates higher for longer as opposed to earlier this year. Cuts were priced in, that would be at 4% or lower by the end of next year and that’s already pushed upward.I think that there’s a difference between the short end of the curve and Fed Funds Rates remaining high versus when they start cutting and the point at which we start seeing that drop. So, I guess it’s a tricky one. We’re close to peak rates, so predicting the exact level is very difficult. 

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Bifurcation: Inflation and Interest Rates in Developed vs. Emerging Market

I think, across the globe broadly speaking, developed economies have been in a hiking cycle over the last 18 months because their inflation numbers have exceeded their targets, whether that’s looking at broader Europe and the ECB or the Bank of England in the U.K., even the Bank of Japan has started to see inflation. But, in other emerging economies like China, for example, they are actually cutting rates, their inflation is very much in check, sort of hovering between the 2 and 3% mark. So China, for example, has room to continue cutting rates. We’ve seen a lot of developed economies begin a rate-cutting cycle. So, if you were to just simplify it broadly, large Western developed economies are getting close to peak rates, maybe a few more hikes, but certainly not cutting, whereas in emerging markets, whether that’s Latin America or places like some of the Southeast Asian countries, they’ve started to cut rates.  

There’s a bit of a bifurcation between the developed and emerging world in interest rates. That’s very difficult. Inflation is higher in some places than others. For example, in the U.K., fortunately, the last inflation print was better than expected, i.e. lower than expected, which is good news, but it can be stickier in certain economies. So, countries with flexible labour forces, for example, where you can hire and fire more easily, like the US, don’t have the labour wage inflation pressure that some places like the UK would feel. If workers see higher inflation, they demand higher wages and we spoke earlier before we started about strikes relating to the train and South West Trains that I catch every day are permanently on strike, it feels like. So, if labour unions are very powerful in an economy and inflation is there, that demand high wages and then that in itself can cause the wage inflation spiral. I don’t think that’s likely because the main drivers of inflation, if we go back to the sort of period of the late 20, 21, early 22 when inflation started moving up, were pent-up savings from households, developed economies that had received fiscal grants and people who had been saving their money because they were locked down in COVID are coming out and saying, well, I’ve been saving all this money. I’ve been desperate to get out and spend it. We saw boosting consumption, and demand for goods and services as households started to spend their savings.

We’ve now seen a lot of the savings rates drop meaningfully as people have spent that money and that was one driver. Then coupled with that, you had supply chain issues around the world in the post-COVID period, expensive shipping rates, and logistical issues at ports. China’s still been in zero-COVID for an extended period of time. China makes lots of components that feed into developed countries, manufacturing processes for, let’s say, a new car. We saw second-hand car sale prices spike and new cars not being made because components weren’t coming from China for example. So, the second was this disruption to the global supply chain, which has now abated to a meaningful degree, if not completely. 

Then we had the Russia-Ukraine war kick-off, which caused a spike in energy prices. That confluence of the three things, pent-up savings being spent, which is on the demand side, supply issues due to supply chain bottlenecks the second pillar, and then the third being this spike in energy and other commodity prices, like some of the food commodities like wheat, for example. Those all drove inflation at the same time. 

Inflation Spikes Easing, But Developing Markets Face Recession Risk

So, the inflation spikes we saw, we don’t think will persist. We’ve started to see inflation numbers coming in. Our view would be that inflation continues to come in whether it’s in one year, 18 months or two years when we hit central bank targets, it’s very difficult to gauge. But the good news is it is coming in across the developed markets and we could see as we move into next year potential rate cuts because inflation is coming in. 

The other side of that coin really is, that having had higher rates now, this could trigger a recession in many developed countries. If a recession is triggered, there’s market disruption in various aspects of the market. Let’s say, for example, the banking sector, which in Q1 this year started to see the effects of higher interest rates, sort of a mismatch between the duration of fixed income within bank assets pulls. If that disruption occurs, the good news is that if you take the Fed, the ECB or the Bank of England, they’re at higher base rates now, so there’s room for them to cut. Whereas post-GFC, in the zero rate or negative rate world, there was no more flexibility to drop base rates. So, the stimulus was via other mechanisms like quantitative easing. 

I think we’re in a good position in that central banks can act swiftly and in a coordinated manner if there is more extreme disruption. So, inflation is very tricky to predict, but overall, it is coming in. We think the three pillars, broadly speaking, that drove that inflation are all somewhat behind us. 

Bullish on China: Attractive Valuations and Priced-In Challenges

So China is a very big topic in financial markets, depending on where you sit and also geopolitically, of course. Now, as I’ve discussed with Alec in prior interviews, it will be a long term investment in China from a strategic allocation point of view. We feel China is underrepresented in major indices due to its contribution to global GDP, its contribution to global GDP growth, the size of its population, and its increasing urbanisation. The scope for China to become a more developed economy is still there. It’s been out of favour because of its rise in terms of Western rhetoric and geopolitics. The good news is, it trades cheaply. So, a lot of the bad news is priced in, but we’re reasonably optimistic about China, its underperformance has created a valuation opportunity. It’s the earnings of big Chinese internet and tech companies have been strong, and revenue growth has been strong, but they trade at sort of on a broad index of internet companies in China on a 22 times multiple of earnings, whereas the US equivalents of China’s internet companies trade on a 34-35 times earnings. So, there’s already a valuation discount there. 

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Positive Geopolitical Shift: China Softening Policy Toward Big Tech Platforms

If you then think about policy, a lot of policy announcements made towards big platform businesses in 2021, 22 period from China caused a sell-off in those names. They’ve somewhat now stopped making big policy changes and are supportive of these platform businesses, which are part of their intention as a government to improve the lives of their 1.4 billion people. Furthermore, we’re seeing improvement on the geopolitical front. We’ve had Blinken, Yellen and Raimondo senior members of the US Congress visit China recently. Hopefully, Xi and Biden will meet at the APEC summit coming up in San Francisco in November. So, on the geopolitical front, the relationship between the US and China seems to be improving. It’s far from a perfect state, but that’s because the West is somewhat threatened by China. China is leading in so many areas, whether it’s battery technology or electric vehicles. They’ve got the greatest number of processing facilities for a number of the commodities that go into the clean green energy revolution. They’re the leaders in battery technology, leaders in wind turbine assembly, and they are selling their product now into the West because there’s a demand from the West to become cleaner and greener. So, for varying reasons, we continue to like China, but it’s a difficult market to own given the constant negative rhetoric towards it. On the negative side, only 4 or 5% of China is owned by foreigners, whereas in the US for comparative sake it is 35% of foreigners’ stock. 

So, it’s not widely owned by non-Chinese investors, which is obviously somewhat positive, because if that moved from 5% ownership to 10% ownership, that would be good. They’ve also been opening up their capital markets. I mean many people don’t realise that whether it’s MSCI Indices or whether it is FTSE indices, they’ve all increased their China inclusion over the last few years as a part of that index, but it is still underrepresented, if you think of it in terms of contribution to global GDP, size of their capital markets. So, the scope for further inclusion is there, but they have already been increasing. The bond market similarly, China’s bond market now makes up over 10% of the global aggregate bond index. That’s happened in the last few years. The currency markets have been opened up, you have the Shanghai-Hong Kong Stock Connect system which connects outside investors to mainland China and vice versa. So, overall capital market activity in China is increasing and it’s becoming more accessible. Yet, we don’t read about that in the press. So, we like China. We’re cautious about our allocations. We’re not going to be at 50% China. But overall, we like it.

Exploring Asset Allocation Shifts: Transitioning to an Equal-Weighted S&P Index

We had a very strong rally, but that’s somewhat abated in the last few weeks and months. I think part of it’s a healthy correction, markets may have got a little bit ahead of themselves, given the uncertainty with high rates. The way we’ve been thinking about it is as we go into a potentially slowing environment with a risk of recession, our base case would be in the US we probably don’t have a recession as defined, but there’s certainly going to be a slowdown. So, we’ve been thinking about valuations and where we want to allocate capital.

One of the changes we’ve made in our portfolios is to move some of our S&P 500 allocation into the S&P 500 Equal Weight Index. So, the traditional S&P 500 is a market cap-based index. So, you end up owning more of the larger companies because they’ve got bigger capitalisation, whereas the Equal Weight owns an equal share of all of them. So, by owning Equal Weight, we effectively underweight some of the very large-cap technology companies, and communication services companies which have rallied very hard. It’s interesting if you look at the, I think it was the 20th anniversary of the Equal Weighted Index on the S&P at the end of last year, it had outperformed the market cap-based S&P by about one and a half per cent. I think it was an 11.5% annualised return on the S&P 500 Equal Weight Index over the 20 years versus a 10% return on the market cap rate. But, in recent years the market cap index has significantly outperformed these large technology companies. Our view would be that perhaps that corrects itself over the coming months and years and inherently by owning a lot of those equal-weighted companies, that’s more of the smaller companies in the Equal Weight Index, you own companies that often trade more attractive multiples. So, that’s one of the changes in our US allocation. 

The second, which we haven’t yet initiated, is looking at the mid-cap names within the US stock market. So, you’ve got the S&P 400, for example, and again mid-cap stocks over 28 years, if I’m correct on the exact numbers, outperformed the large-cap stocks by 2%. So, as we move into a different world where you’ve had this very strong bifurcation between your big, strong tech communications services winners and the rest, which have often performed poorly or flat, we think it might be an opportunity to rejig our allocation within the US. As pertains to other regions, we retain a slight overweight to China as I’ve touched on.

Taking the Long View on Clean Energy Stocks 

Within Europe, we’ve positioned ourselves a little bit more defensively, moving some of our more cyclical sectors like European autos into European healthcare, which is a more defensive sector. Then another more recent trade that we’ve done in portfolios is if you followed clean energy stocks which is a broader theme, we like taking a 5, 10, 20-year view on allocation. The wind and solar companies sitting within a clean energy ETF are appealing to us long term, but around the margin, you can also tweak your weighting. So, given the selloff, we’ve seen a lot of these names driven partly by lithium-ion prices rising massively and also higher interest rates seeing a meaningful drop in the clean energy stocks and therefore the ETFs. So, we’ve started to increase our allocation to those as well. Those would be some of the more recent changes we’ve done in our portfolios. But it’s a very difficult time. We’ve got uncertainty on the horizon relating to the economy, uncertainty relating to how high-interest rates go or for how long they stay elevated and what the knock-on effects will be. So, you know, it’s not easy given we’ve had a good move up from Q4 last year already. 

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Could Post-Election Policy Changes Impact Capital Allocation?

Forming a strong view on how policy will change post-election is very difficult in allocating capital. Firstly, you don’t know who’s going to win the election, that’s probably number one and then whoever wins the election, knows for sure which policies get passed because often there is a requirement for coalition government and it’s very difficult to pass new legislation which might impact stock markets. But, there are certain things you can look at. In general, if you have a Republican versus Democrat, House or Senate, what is the impact on markets? The Senate changes every six years. The House changes every two. We’ve had big news about McCarthy, so, there’s a lot that can change very quickly. But normally what we would do, is think more about, given the change, if there is now an opportunity post-event. So, we are trying to read the likelihood of policy post-event, but predicting election outcomes is very, very difficult and we wouldn’t make broad-based allocations based on sometimes guesswork on how the election pans out, but it’s a catalyst for activity.

 So, we trade around drivers of investing or valuations and where we are on the cycle whether it is monetary policy or fiscal policy. Fiscal policies are linked closely to governments, monetary policy is supposed to be independent of the government, but monetary policy and fiscal policy are very important and then geopolitical sentiment. The Trump period in terms of his anti-China rhetoric presented an opportunity to some degree in allocations to China, which then rallied. We’re now still in a period of uncertainty as to how geopolitics unfolds with China. That’s just one example. We’re also looking at Brazil and how policy changes there following the change of leadership could impact in the longer term the stock markets and Brazil’s relationship with China and the new BRICS Plus set-up. So, we’re aware of all of these things, but you’ve got to think very big picture geopolitically and macroeconomically as to how it might change. Sometimes people just guess and we don’t like to guess, we’d rather have some level of certainty and then balance risks carefully. 

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