May 2022
Why it is still important to take a long view when managing volatility
Welcome to our latest market update
This month we have a special, in-depth edition on the importance of taking a long-term view on your investments. We’re grateful to our friends at Charles Stanley for their input into the content.
Over the past 12 weeks it has become clear that we are not military experts, which makes a refreshing change after two years of learning how little we knew about epidemiology. Like the pandemic before it, the war in Ukraine is a great reminder to investors, and everyone else, of the virtues of humility and recognising what you don’t know.
After the recent period of market turbulence, it is interesting to read surveys asking how bullish are we feeling? If the American Association of Individual Investors’ weekly survey is anything to go by, the answer is ‘not very’. The survey, which has been carried out for decades, is keenly followed as a measure of sentiment. Retail investors are simply asked if they’re feeling bullish, bearish, or neither. This week, fewer called themselves bullish than in any week since September 1992 and in the last 30 years, bears have outnumbered bulls more than they do now just once. That was in the second week of March 2009, in what turned to be the last survey before stocks hit rock bottom and started their great post-Global Financial Crisis rally.
This is quite something, especially if you consider that this implies that investors were more optimistic just after 9/11, during the Covid lockdown, and in the throes of the Global Financial Crisis, than they are now.
Most of us can appreciate why sentiment is weak and shaken at present. But the reported lack of bullishness on this scale is startling. What can shake markets out of this doom? It may be the fact that both fixed interest assets and the trusted assets that have done so well for years have floundered over the past few months.
But it is really as bad as these investors fear?
Perhaps the greatest reason for hope at present is that almost all hope seems to have been lost. Yes, sentiment is low, but sentiment can change quickly. On balance, it could be suggested that the lack of bulls is in itself something to be positive about and needs to be listed on the positive side of the ledger for anyone considering whether to buy. If there are that many people who are unconvinced that things can get better, then any good news should have a higher positive effect on share values as time goes by.
We accept that the narrative late last year that we would see the economic recovery extend into 2022 has been dealt a sharp blow in the first quarter. We also know that many economists have lowered GDP growth forecasts and raised inflation forecasts for this year.
So, a more interesting question is why so few investors are bullish? We know that the Russia-Ukraine conflict has activated a key risk to a recovery base case and the additional COVID-19 lockdowns in China have also accentuated existing supply disruptions. The impact of energy and food price inflation is yet to be fully felt around the world. But surely these have already been priced into markets to a certain degree.
Judging the probability of unlikely but damaging events has always been a problem for markets. As none of us have ever experienced nuclear Armageddon, it’s possible we’re underestimating such a risk. Whereas most of us have clear memories of a market crash, therefore this may be a risk we’re overestimating. Once again, that in turn creates more opportunity for stocks to rise from here.
Sad as the ongoing news reports are, it seems as though the conflict in Ukraine has somehow become yesterday’s story. Looking at two good measures, global Google searches and total stories published by Bloomberg each day with the word “Ukraine,” the fact that they are often third or fourth stories on the newsfeed supports that interest in the subject has fallen significantly.
Why it is important that we don’t panic and sell when markets drop
As we have pointed out before, we live in an era where market volatility is a fact of life. While global markets offer access to attractive long-term capital growth and income opportunities, market pullbacks happen frequently, and often. Fortunately, there are several strategies that investment houses can use to make sure they are best positioned to ride out the market’s ups and downs.
If we accept that drawdowns are part and parcel of investing, we should be reassured by a recent article from JP Morgan where they pointed out that of the last 35 years, close to 70% of the time markets ended the year in positive territory and, most importantly, that stock markets have mostly ended in positive territory, even in years marked by intra-year declines of more than 10%. Consequently, we can see that very recent performance is not a reliable indicator of current and future results. Selling when markets are volatile therefore risks locking in losses when markets bounce back.
In the last 10 calendar years, a portfolio investing in a combination of developed market and emerging market equities, investment grade bonds, and other assets has delivered healthy returns with much less volatility than investing in equities alone. We also have to bear in mind that the strongest performing assets since early 2000 have also tended to be those whose prices have been the most volatile.
We also have to appreciate that central banks are trying to control domestic policy and inflation that is being driven by global issues. We therefore have to monitor consumer spending trends especially as more and more governments are increasingly trying to steer their economies to a consumer driven focus. Recent trading updates from airlines, tour operators, and the hospitality sector suggest there remains quite a high propensity to spend, even if the housing market can reasonably be expected to be coming off the boil.
Despite the advice of a certain minister, past experience of inflationary surges suggests that shoppers will seek to buy more promotional items, switch to cheaper brands, buy fewer products or buy more supermarket own-label items. Recent surveys point to that happening this time too, with only a quarter of all households continuing to spend in the same way as they have in the past. Except that, again, the current situation is unprecedented. Wages in some sectors, particularly in tech and life sciences, are rising much more strongly than in the early 1990s. Moreover, the last time inflation was rising at this pace, there was no internet, no online advertising, no ecommerce, no social media, no price comparison websites. Consumers today can shop around in a way that they could not in the early 1990s. That presents a challenge to retailers and the fast-moving consumer goods sector. They cannot necessarily pull the levers they did in the past, especially as the internet now accounts for 30% of goods sold.
As we have highlighted before, no one under the age of 48, which is just over half the UK’s adult population and a significant majority of the working population, has known inflation like this in their adult lives. The Bank of England has now responded with four consecutive interest rate rises, something not seen for 18 years. In addition, homeowners under 44, or perhaps closer to their late forties in some regions, have typically known nothing other than interest rates at close to zero. We are therefore in uncharted territory, making it difficult to forecast precisely how the present generation of borrowers will respond to higher mortgage rates, particularly because a chunk of the population built up significant savings during the pandemic.
In tangible ways, the market now believes that the American Federal Reserve is prepared to go through with hiking rates until excessive prices have been stamped out, even at the cost of an economic slowdown. Sharp increases in the cost of money matter a lot to the economy. They make borrowing for a house more expensive and endanger the store of wealth represented by the housing market. They also make it more expensive for companies to refinance their debt.
The less your portfolio looks like the benchmark the better
We recently read an article where a crypto investor was asked if he was worried about his new wealth being concentrated in such a volatile asset. He replied that he was diversified – he owned multiple cryptocurrencies and had a broad NFT (non-fungible token) portfolio. We know from hard-earned experience this isn’t true diversification. It is false diversification, maybe what the famous American investor Peter Lynch called di-worsification.
When we read articles where investors believe that they have taken action to reduce risk, we usually see two recurring themes. Firstly, when investors contend that the risks to their portfolio don’t apply to them. Secondly, where once there was a large allocation to listed equities, there is now an increased weighting to private equity and venture equity. It is important to stress that all equity – private, public, and venture – is subject to the same underlying economic forces.
There is no secret sauce, just more leverage, higher fees, and less transparency. The fact that these assets are subject to less frequent pricing only lowers the volatility on paper. So, they may appear less volatile, but price movement will eventually catch up and they are also subject to higher concerns about liquidity. The risks implied by a recession, higher corporate taxes, multiple compression, and inflation are all the same regardless of whether the equity is public or private.
This is the illusion of diversification
This doesn’t just apply to the equity side of their portfolios. Government bonds now offer return-free risk (as opposed to the preferred vice versa). Over the past two years, the buy-and-hold total return on a 10-year US Treasury bond in real terms has been -20% (that is a minus figure on what is meant to be the risk-free asset of choice). That’s the worst inflation-adjusted performance since 1981. So, it brings us back to a dilemma where fixed interest assets are meant to be the safe haven when markets retreat if they look overvalued.
Consequently, investors have been diversifying away from sovereign bonds at increasing speed. Moving into investment grade, high yield, private credit, infrastructure, and renewables. In effect, this is swapping one type of duration risk for another, but the credit safety also diminishes as you chase yield in these risky assets. So yes, the momentum has kept prices high, but it has just pushed the problem further along and it will catch up with these investors. Please remember that as a general rule, the more of an investment’s value that lies in the future (its duration, in financial parlance), the more it will be hurt by rising inflation expectations. For the ultimate exemplar, we have watched the price of Austria’s “century bond,” which won’t be repaying its principal until the year 2117 since it was issued in 2017. Over the last few months its price has virtually halved since last year. Again, that is a major European Government’s loan.
The predominant driver of returns in these assets is a sensitivity to interest rates. It has been favourable for the past 40 years, but this is beginning to reverse. If we consider a 40-year infrastructure asset currently valued using a discount rate of 6%. Bearing in mind interest rates in the UK are currently at 1% and if we assume they rise to 2% by the end of the year, then it would be fair to assume the discount rate for the investment will rise to, say, 7%. In that scenario, the net asset value of the investment falls by 16%. That is meant to be the low risk assets in the portfolio.
Therefore, the rarest and most valuable assets or strategies in the investment world are going to be those which are truly zero duration and those which are truly uncorrelated.
But where do these mythical investments exist? It does mean moving out of conventional assets to unconventional assets and may require investors to be far nimbler, which is heresy when we have all been taught to take a long-term view. If you believe in a new, more volatile inflationary regime this comes with greater market volatility and this turmoil will create opportunities for those who can be nimble and tactical.
The best returns will be found in the tails of the new era
On the extremes, we think there is a chance we get a stimulated growth boom, another roaring 20s, driven by fiscal stimulus to tackle the big social issues – climate change, societal inequalities, and the containment of Chinese and Russian geopolitical ambitions. These are (still) some of the cheapest sectors of the market, implying investors consider this right tail outcome a low probability.
Where we don’t want to be is in the middle of the distribution, i.e. hoping for a resumption of the old regime of low and stable growth and inflation. The winners of that regime were tech, quality growth stocks and long duration assets like venture capital and infrastructure, which look extremely vulnerable to the rising interest rates and risk premium environment.
Yet this seems to be where most investors are exposed.
We can’t peek around the corner, but it’s becoming increasingly clear that what lurks there is a threat to investors. So, we need to hold our nerve and remain cautious, especially as we consider what needs to happen if we are to see a reversal in market. Simplistically, there needs to be a successful transition from markets being over accustomed to huge amounts of cash being injected into markets via quantative easing, to relying on old-fashioned company earnings to restore equity market gains.