Cover story – Recession
When Michael Burry bet against the US housing market in 2005, it nearly cost him everything. Back then, the hedge fund manager, whose story has been immortalised in the movie The Big Short, was in the minority. Ben Bernanke, the Fed’s chair at the time, famously stated weeks before the collapse of Lehman Brothers in 2007 that problems in the sub-prime mortgage market were unlikely to hit the broader economy. Only geeks and a few lucky short traders predicted a recession. This time around, it’s different. The combination of rising inflation, overheated financial markets, strained supply chains and struggling household incomes makes this downturn widely anticipated. The alignment of macro-economic factors could not be any worse.
And the picture is especially bleak in Britain, where a shrink- ing workforce, trade worries and falling household incomes are looking so dire that the governor of the Bank of England, Andrew Bailey, has warned of an “apocalyptic” impact on food prices. The Bank of England had already raised interest rates higher than in other developed markets when inflation hit 9% in May. With the hawks taking over Threadneedle Street, Wash- ington and Frankfurt, recession is lurking around the corner. According to Bloomberg’s economics survey, 40% of respond- ents believe there is a chance of a recession, while a Bank of America Merrill Lynch fund manager survey revealed that an overwhelming 71% of fund managers are pessimistic about the economic outlook.
But despite this gloomy forecast, simply de-risking by buying gilts is no longer an option for institutional investors, not least because bond markets are overheated following a decade of dovish monetary policies. Schemes are still under pressure to deliver returns. So, how does one invest in a downturn?
Volcker 2.0?
The ability of central banks to contain inflation will be the start- ing point for most investors. Whether rate hikes will succeed in reigning in price rises has repercussions across all asset classes. At the same time, talks of rising interest rates bring back bad memories. In 1980, Fed chairman Paul Volcker raised US rates to an eyewatering 20%. Whether those measures were decisive factor in containing inflation remains disputed, but price levels did climb down to the lower single digits throughout the 1980s. But the rate hike came at a price. By 1985, US GDP growth had dropped to -3%. That is precisely the scenario many investors are now fearing.
People overestimate the power of using monetary policy to fine-tune infla- tion. It is largely a non- monetary phenomenon anyway.
Stuart Trow
Back in 2007, central banks managed to avert some financial pain by injecting huge sums of money into the economy and lowering interest rates. But now they are gearing up for mone- tary tightening. Efforts to mitigate the economic damage caused by the pandemic have ballooned the Fed’s balance sheet to more than $8trn (£6.4trn), it now plans to reduce its assets by $30bn (£24bn) and subsequently $60bn (£48bn) per month, whilst also increasing interest rates. Over in the UK, the Bank of England raised its bank rate to 1%. Higher borrow- ing costs will hurt businesses and consumers alike. An early indication of that is the Red Flag Alert by Begbies Traynor, which tracks levels of corporate distress. The number of county court judgements in the first quarter increased by 157%, year-on-year, and the data provider predicts “a wave of business failures” due to the combination of fiscal and mone- tary tightening and inflation. Richard Tomlinson, chief investment officer at Local Pensions Partnership Investments (LPPI), is confident that rate hikes will eventually succeed, but is worried about the wider ramifi- cations. “Central banks will ultimately control inflation but the questions are: what path that takes, whether you end up with a soft or hard landing and if we will enter into a recession.” While he believes it is unlikely that rates will reach similar lev- els to those seen in the 70s and 80s, he is nevertheless wary about the economic impact. “Since the end of the Second World War, we have seen 14 significant Fed rate hikes: 11 of which preceded a recession. If you are calibrating off that as your data set, the probability is that we will end up in a reces- sion,” he says. Jonathan Cunliffe, managing director of investments at B&CE, the organisation behind The People’s Pension, has a similar view. “My sense is that policy will be tightened sufficiently to
18 | portfolio institutional | June 2022 | issue 114
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