From Stagflation to Goldilocks, portfolio managers start thinking small, Mazars

by | Sep 11, 2023

George Lagarias

Written by George Lagarias, Chief Economist at Mazars

Going into the final stretch of the year, the one thing we can tell with any level of certainty is that we now know even less than we did going into it.

To be sure, our theme from the beginning of 2023 was “prolonged disruption”. But deep down, I had hoped that I was wrong. That as the year progressed and we climbed the peak of the interest rate mountain, we would look around and gain clarity.

Alas, the view keeps shifting and the landscape looks like a perma-crisis. Some days I feel like Dante who found himself travelling down nine circles of Hell, only to figure out that climbing Purgatory came next. 

The pandemic, which came on the tail of a trade war and geopolitical tectonic shifts (see “India is the new China”), has upended the stable post-GFC regime and thrown the global economy into turmoil. In this environment, everyone sees what they want to see. 

At one end of the spectrum, is the “Goldilocks” crowd. They believe the economy has underlying strength, the labour market will remain strong and that consumers will only marginally curtail their spending. A shallow recession awaits if any recession at all. However, inflation will still come down enough or a financial accident will happen, either of which will force the Fed to begin cutting rates at some point in mid-2024. Presently, markets are in this camp. 

At the other end of the spectrum lie the “Stagflationists”. A decade and a half of bad news, for that crowd, can only be followed with more bad news. In this scenario, the economy slows down materially, as consumers run out of pandemic pocket money, consumption falls off a cliff and delinquencies rise quickly. The labour market loosens quickly companies with high levels of debt find it difficult to keep bidding talent up. However,  inflation remains stubbornly high due to continuing shocks to the economy, which begins to look like a replay of the 1970’s. 

As always, the truth is probably an amalgamation of the two scenarios. Some would say that the needle points to the latter, some would have it tilted towards the former. 

We think this is less relevant than the general picture, which is one of utter lack of visibility. No one really knows how consumers are going to behave when they run out of money. They can keep spending if the labour market remains tight. Or they might keep “quiet quitting”. Or any other behaviour might prevail. In the same way, no one knows where energy commodity prices will go next. Russia has every interest in hiking prices. Saudi Arabia might want to test the upper limit of the $65-$90 range, now that it has learned the limits of US shale production. 

The Fed admits it doesn’t know, which is why last week a slew of officials said that the US central bank has entered a “wait and see mode”, which probably means pausing rate hikes again in September but keeping their options open. 

Markets won’t admit that they don’t know, but the truth is that they have been consistently behind the curve and overoptimistic in terms of rate hikes and potential rate cuts. 

So how will portfolio managers play this? 

To be sure, “I don’t know” is something that’s not said often in our world. But it is very much implied when fund managers stick close to their benchmark. 

For example, if one could be confident that the US 10y yield would fall back to 2% in a couple of years, they could make 20%, outperforming what stocks give you on average (8% per annum). But with the possibility of further external shocks to inflation, how can one be certain what will happen at the long end of the curve? 

How long can one stay hidden behind the shadow of their benchmark, when they are paid to outperform it? How can managers add value to portfolios when visibility is so low, and any bet is a low-confidence one?

In comes Enrico Fermi. Fermi was an Italian Physicist (1901-1954), who created the world’s first nuclear reactor and who served in the Manhattan Project. This lesser-known Oppenheimer posited that any problem has a solution, as long as it’s broken down into smaller pieces. 

 If one can’t have a clear view of what comes next, then one may opt for a clear view of smaller corners of the market, or a clear view of which funds/stocks may outperform. 

We have often said, and will again reiterate, that portfolio outperformance in this market is not about getting the larger picture right. One can still do that of course, but it is a low-confidence bet. Which means that the risks to their investors are significant. 

Rather, it is about getting the security selection right, the industry selection right and the geography right. Asset allocation still works, make no mistake. But more certainty can be found below the top-line decisions (stocks or bonds), in the smaller and less exciting questions.

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