Direction of interest rates top of mind in planning asset allocation decisions
Early indicators are showing that inflation may finally be turning the corner, but advisors should still be carefully positioning portfolios for what lies ahead, says one experienced portfolio manager
“What we’re really focused on right now, as a team making our allocation decisions, is inflation and the direction of interest rates,” Christine Tan, assistant vice-president of portfolio management for SLGI Asset Management, told Wealth Professional.
Although she has a background in emerging markets, Tan’s role is to look at all the key drivers that might change their asset allocations, and she said the consumer price index isn’t the best gauge of how the central banks’ monetary policy is influencing inflation because it’s a lagging indicator. She relies more on some of the components in the Purchasing Managers’ Index (PMI).
“The reason we’re focusing on inflation is we want to see it start to trend down on a sustainable basis,” she said. “That will give us some level of comfort or visibility that the central banks are closer to an end in the rapid pace of rate hikes. That will be positive in terms of what it means for asset prices, what it means for bond prices, and potentially what it means for whether or not we achieve a soft landing or have a hard economic landing. The soft landing would be if the central banks can get the economy to slow down to a low single digit, but it doesn’t quite turn negative.”
Tan said that focusing on inflation will drive her view on the interest rates as well as what earnings could look like. If the landing is softer, earnings may not decline as much as feared.
“We’re really waiting to see when the pace of rate hikes will start to pause and potentially just stop at some point,” she said. “Until that point, we still have a cache of what we call a tactical cash buffer: so, not a long-term cash call, but we’re just waiting for opportunities.”
Tan said some of the PMI’s components are showing that supplier delivery times are improving and input prices have decreased. But, she noted that the central banks now are concerned about the inflation anchor in case consumers begin to anchor their inflation expectations higher than 2%, which could then drive wages up.
While the banks are expected to continue to be aggressive and keep rates higher for a little longer to ensure that inflation finally drops, Tan said that SLGI is positioning its multi-asset portfolio to focus on quality businesses with experienced management teams who have been through an economic cycle or two. Oil companies are still good, even though prices have declined, as long as their balance sheets are strong.
“The other reason we want to focus on quality is we think we’re headed into a slowdown next year,” she said. “Whether it’s a hard or soft landing really depends on the geography. We think North American – Canada and the U.S. – are more resilient. Europe is really challenged by the inflationary pressure of the Russian incursion, and it was facing a slower growth environment anyways. So, Europe is definitely at high risk of stagflation.
“From an individual holding perspective, we like quality bonds.,” she added. “In the world today, one of the few benefits of what we’re going through is we’re now earning something on our bonds. So, that’s an area that we’ve been cautiously deploying some of our cash into core government bonds. We’re also being very careful about taking on credit exposure with the view that we’re heading into a slowdown next year. So, we’ll be a little cautious on high yield credit.”
Tan noted that the spread over investment grade or government bonds is very tight, so it wouldn’t compensate SLGI to take on that credit risk. So, for now, it is remaining underweighted in bonds, but overweighted in government bonds, which presents some opportunities.