UniSuper's investment chief John Pearce says the fund's cash holdings have risen to record levels as stocks plunge to new lows on fears that steep rate hikes to fight inflation could tip economies into recession.
As for where equities are heading, the investment chief of the $108 billion super fund warns that a clear picture might not emerge for months.
Pearce warns that the sharp sell-off in stocks may not just be an extension of what we have seen over the last decade and that the markets have entered a new era.
"What's different about this market sell-off is that we have really ugly inflation, and therefore the response has to be different," he says.
"What's worked in the last decade is really not going to work for the next three or four years or perhaps longer."
He cites the global financial crisis in 2008, the European debt crisis, QE, and then Covid- all of which caused big market sell-offs. "Even with 10 to 20 percent falls, you closed your eyes and kept buying because, without inflation, you knew that central banks would come to the rescue at the end of the day.
This time, a central bank rescue is not on the cards.
Pearce thinks they would be happy to see equity markets tank since a negative wealth effect would help crush inflation.
So that being the case, what should investment chiefs do?
Staying the course
Pearce is arguably the most hands-on investment chief in the industry. More than 70 percent of UniSuper's assets are managed internally.
Moreover, he is a big believer in staying the course. He has always been against positioning a portfolio for the big one-off geopolitical events.
The reason is that members in the accumulation phase of super should ignore the market volatility.
"We are in the "ugly" stage of the financial cycle, but the cycle never dies, and an upswing is inevitable. History is not kind to long-term bears. However, timing the upswing is impossible."
Right now, though, Pearce is accumulating cash.
Of course, he is looking closely at some companies in the hardest-hit sectors judging them against other relative value opportunities as he works out whether it is too soon to jump in.
"On a relative basis there are some quality companies that look good, but on an absolute basis we are only one bad inflation figure away from another drop in the markets, so we're sitting back for a while."
Pearce describes three possible scenarios playing out within the next 12 months.
Returning to normal where inflation prints below three percent and both US Fed and the Reserve Bank of Australia put tightening on hold is one option." In this case, we are probably setting ourselves up for the next good rally in equity markets, he predicts.
However, he warns it is equally likely we will slide into recession. Nor is he ruling out the probability of stagflation.
"So, if you look at those three scenarios, two of them are pretty damn bad."
With no shortage of bad news, is there any good news for members? Have markets now priced in enough bad news to create buying opportunities?
The investment chief concedes that "a fair bit of bad news" is already priced into markets.
As he sees it, the equity, bond, and crypto markets have borne the brunt of the bad news so far.
Importantly, he points out, while the credit markets might have sold off, they're currently not signalling recession.
Markets moving lower
Even though a sharp 20 percent sell-off swept the markets, Pearce calculates a recession would see another 20 percent plunge.
"The question is how deep the recession is going to be? If it's mild, we could get a V-shaped recovery in markets after a short sharp sell-off
"A protracted recession is when you really got to worry."
The risk is of ending up as the greater fool, but Pearce says we won't know for some time who that is.
"It could be that the smarties are the ones that are plowing money into the markets now on the basis that we have seen peak inflation and the next three quarters will see a steady decline," he says.
"If that happens, and it is a possibility, they will be the real winners."
However, that is not UniSuper's base case. Pearce believes inflationary pressures are persistent and argues that there is too much emphasis on supply chain bottlenecks causing inflation and too little recognition of the demand side.
"Demand is all about income and money and credit. Labour markets are tight, wages are growing, and incomes are growing, so there's your demand factor."
The main issue for Pearce is whether central banks somehow orchestrate a smooth landing rather than raise rates to the point where economies move into recession.
And from where he sits, that depends on how central banks respond to early signs that they're going too hard into over-tightening.
Betting on aggression levels is difficult. For example, the Reserve Bank of New Zealand is ultra-hawkish, the Reserve Bank of Australia is on the dovish side, and the Fed is somewhere in between.
"I think the RBA needs to step up the pace; two 50-point hikes would get them back on track."
Turning to major investment themes, Pearce notes that trends that dominated financial markets before the pandemic - decarbonisation, technology, and Asia's emerging middle-class - remain.
But the critical theme is the lower rates for longer since that changed the world dramatically.
We have gone through three decades of falling rates so are we now in for three decades of rising rates? Or, are we going to hit a level that is still pretty low and plateau there for decades? That's the million-dollar question."