The biggest fear for trillion dollar managers is missing from the next rally

(Bloomberg) — Some of the world’s biggest investors are looking not only at rising interest rates, bank failures and the threat of a recession, but also at one of the biggest fears of all money managers – missing out on the next big rally.

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For $1 trillion investment groups Franklin Templeton, Invesco and JPMorgan Asset Management, the mounting financial volatility seen at Silicon Valley Bank, Credit Suisse Group AG and First Republic Bank is a signal to speed up preparations.

They are convinced that the impending slowdown in the US and other economies will force central banks to return to more accommodating policies, which will trigger a new bounce in the markets.

“If you miss the start of the rally, you’re missing out on a lot of earnings,” said Wylie Tollett, chief investment officer of Franklin Templeton Investment Solutions, a division of the $1.4 trillion fund manager. “It’s very difficult to catch up if you miss the first week or two. Sometimes it’s just days.”

This imperative is driving big investors into long-term bonds, eyeing last year’s big losers like tech stocks and selectively buying riskier assets like private loans.

Bonds

“Fixed income is back,” Hong Kong-based Tollett said on a trip to Asia to meet big investors. His firm is adding government bonds with longer maturities from the US, UK and Germany.

JPMorgan’s investment arm has bought more long-term fixed-income treasuries in recent weeks despite the prospect of losses if interest rates rise. The danger of holding too few bonds when the Fed’s reversal triggers a rally outweighs any short-term depreciation, said Bob Michel, who as chief investment officer helps control $2.5 trillion in assets.

“My main concern is not what we are buying now, but yields will rise another 50 basis points,” he said, noting that prices are still the lowest since the financial crisis. More worrying for him is that he will be out of the market when the situation changes.

The Australian Pension Fund, one of the country’s largest pension funds with $159 billion in assets, is another investor that bought public debt this month.

“We are back to a neutral fixed-income fund,” said Andrew Fisher, head of investment strategy at ART. The pension fund is expected to move into an overweight position when returns pick up slightly.

Stock

Invesco, which controls $1.4 trillion in assets, expects the Fed to pause in the coming months before moving into an easing cycle later this year, sparking a stock market rally.

“If the downturn in the economy occurs in the second half of 2023, the stock market will expect a recovery in 2024,” said Christina Hooper, the fund manager’s chief global markets strategist. “Tech companies are responding very well to declining earnings, which is broadly positive for stocks.”

Invesco will look to an excess position in cyclical and small-cap equities as signs of a Fed turnaround become clearer, and relinquish its prudent stance in large and defensive sectors such as utilities and commodities.

According to Rob Arnott, chairman and founder of Research Affiliates LLC, stocks with low price-to-earnings ratios in mature markets such as Europe, the UK and Australia offer attractive opportunities.

“I would be exposed to markets outside of the US, both developed and emerging markets,” he said. He points to British equities, which are trading at a price-to-earnings ratio of about 10 compared to nearly 18 for the S&P 500, as a valuation mismatch that investors can exploit.

Franklin Templeton is gearing up to move from underweight stocks to equity neutral ownership so as not to miss the early stages of the rally.

JPMorgan data shows that investors who were absent during the top 10 days of the S&P 500 in the two decades leading up to 2022 made half the profits of those who were in the market during the entire period.

Credit

Investment grade corporate bonds have become one of the most popular overweight positions among investors seeking higher yields than government bonds with moderate risk.

“You don’t have to reduce the leverage spectrum to make a profit right now,” said Emily Roland, co-chief investment strategist at John Hancock Investment Management, which manages $610 billion in assets.

The firm has excess positions in investment-grade corporate bonds, mortgage-backed securities, and municipal bonds. This will add riskier debt, such as high-yield corporate bonds, when worsening economic conditions lead to a Fed reversal.

Mohamed El-Erian, chairman of Gramercy Funds Management and advisor to Allianz SE, is also looking at emerging markets.

“In particular, the lending segment offers attractive opportunities,” he said. “The key here is the combination of careful name selection with an emphasis on balance sheets.”

But shifting too quickly to riskier lending could have a downside, Invesco learned this week. The fund manager held additional Credit Suisse Tier 1 bonds that were redeemed over the weekend.

Currencies

The dollar will lose one of its key strengths when the Fed starts to cut rates, while attracting investors who run to it as a safe haven during an economic downturn.

“We are likely to see a slightly weaker dollar, just as we are likely to see a less aggressive Fed. The two will go hand in hand,” said Invesco’s Hooper.

Some investors see things going the other way.

“We’re in the stronger dollar camp,” said John Hancock’s Roland. “As global markets begin to realize that a recession is the most likely outcome, you will receive an offer in US dollars. This is an important element to keep an eye on and will affect all assets.”

JPMorgan’s Michele is also bullish on the yen as Kazuo Ueda will replace Haruhiko Kuroda as governor of the Bank of Japan in April.

“Ueda-san will begin a period of policy normalization and things like yield curve control will be phased out,” he said. “This will result in assets being repatriated back to Japan and you will see a lot of that flowing into yen assets.”

Private Markets

Private markets, which have generated significant profits in an era of low interest rates, are slow to assess the impact of the tightening cycle.

This leaves them vulnerable now that the economic downturn is looming, and Michele is particularly concerned about private credit. But on the rise and in the long term, others are looking for opportunities.

According to Tollett Franklin Templeton, in private markets and elsewhere, investors should be selective in their holdings, not cut back.

“It’s always darkest before dawn,” he said. “If you wait for the actual reversal, you will be late. You must anticipate this.”

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