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Smart money is still wary of the equity rally

Whatever the conspiracy theorists tell you, no one plugs a microchip in to your brain at the registration desk at the World Economic Forum in Davos to ensure perfect harmony of thought.

It is possible the microchips were inserted this year at the Global Collaboration Village — a “purpose-driven metaverse” — just up the main street from the conference centre, but sadly, this correspondent’s schedule did not permit time to find out.

Nevertheless, the consensus around the direction of global markets in the comfortably carpeted corridors of power at the annual get-together this month was striking. In short, the thinking among managers of serious money is: Don’t believe the hype.

Markets have certainly started 2023 in ebullient form, with a gain of around 6 per cent in the MSCI World stocks index before January is even over. That takes the gain since the lowest point in October to a stonking 20 per cent.

Not for the first time, this is fuelled primarily by hopes that inflation appears to have come off the boil and that the US Federal Reserve might therefore be minded to scale back, then stop, then even potentially reverse the interest rate rises that blasted into many fund managers’ returns last year. Futures markets show traders see a near-20 per cent chance of rate cuts by the end of the year.

Just because this narrative has been wrong on several occasions since the start of 2022, it is not necessarily wrong now. But it was hard to find anyone in the Swiss Alps who was buying it.

Nicolai Tangen, head of Norway’s enormous $1.3tn oil fund, is among the party poopers. With a dash of Nordic straight talking, he told me the fizzing market conditions that stemmed from the global injection of monetary stimulus after the outbreak of Covid had pulled a lot of “crap” on to stock exchanges. He said the oil fund’s 2022 performance — a 14 per cent decline in total — was one of its worst runs since inception, but it would have been worse if it had not decided to avoid some of those new market listings.

Now, Tangen said, a good deal of the froth had been blown off the markets, but investors should accept that the Fed may well restart rate rises and that a long, slow grind of low returns lies ahead.

Again, with or without the mind-controlling microchip, big money managers agree this is a likely outcome that a lot of investors are reluctant to take on board. Investors broadly know that this time is different, that 2022 taught everyone that they didn’t understand inflation after all, and that the Fed can stay hawkish longer than you can remain solvent. However, they are still struggling to shake off the muscle memory built up from previous cycles.

“We think we are shifting from one type of environment that existed for 40-plus years,” said Karen Karniol-Tambour, co-chief investment officer for sustainability at Bridgewater Associates, the hedge fund behemoth. “We think we are moving to an environment where inflation will be more volatile, more entrenched.”

That will demand that monetary policy is tighter for longer, even despite the damage this may inflict on the real economy and on jobs.

“The market has had a couple of months of saying ‘maybe we’re back to being back to normal, don’t worry about it’,” Karniol-Tambour said. “We don’t think that’s right.”

Bridgewater’s flagship Pure Alpha fund churned out a gain of 9.5 per cent last year, roughly in line with its long-run average and a performance that long-only asset managers can only dream of. The rise could have been more if Bridgewater had chosen to jump on board the market rally in the fourth quarter. Instead, it stuck to its view that the impact of already aggressive rate rises has not yet played out and that markets are just too rosy.

Jonathan Hausman, senior managing director in global investment strategy at the $250bn Ontario Teachers’ Pension Plan, is relatively optimistic. For OTPP, the answer is to try to look beyond short-term conflicting signals and to hunt for more durable bets in the likes of infrastructure and real estate. It may sound boring and basic, but bonds — both corporate and sovereign — are also more alluring prospects now yields have pushed higher and default risks still seem low.

But he also agreed that investors are working hard to convince themselves that markets are in recovery mode. “The mood is schizophrenic,” he said. “Among the cognoscenti, there’s a sense that the institutions — the Fed and the European Central Bank — are really in this for the long haul, not to be the ones that let inflation rip. Your heart says ‘I think this is going to be OK’ but your head says ‘I know these guys are playing for keeps’.” 

As 2022 wound to a close, the notion that central bankers could quash a markets resurgence this year was seen as a small possibility, high-impact tail risk. But it is clear that the smart money is taking this prospect seriously. If you are rushing headlong in to this rally, this should be enough to give you pause.

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