After dramatic declines across bonds and stock markets, Johanna Kyrklund asks whether markets are nearing a turn in the road yet.
To anyone who ever travels with children, the incessant question “are we nearly there yet?” will be a familiar refrain that punctuates any long distance car journey. It’s certainly a favourite of my seven-year old daughter.
Now, I find myself sounding like her. That’s as I look at the dramatic declines across fixed income and equity markets and think about whether markets are now cheap enough for us to increase our tolerance for investment risk.
So - are we nearly there yet? The answer right now is “not quite yet”.
As I outlined in last quarter’s CIO lens, the challenge is that rising interest rates represent a major regime change after years of quantitative easing.
This policy, which saw central banks like the US Federal Reserve buy trillions of dollars worth of bonds, resulted in interest rates being pinned at zero with the intention of encouraging borrowing and supporting markets.
It meant that investors searching for yield and returns were forced up the risk curve – that is, into riskier assets.
I've previously described this as being like a game of "whack-a-mole", the arcade game in which players must be on the lookout for moles popping out of holes to quickly whack on the head with a mallet. When you hit one, it disappears, and another appears elsewhere.
In the market sense the parallel is that any hint of a yield that has appeared in recent years has been quickly met by a wall of money from investors looking to escape negative real rates. When one becomes overdone, everyone starts looking for the next.
Against this backdrop, volatility was suppressed and any traditional concept of valuation went out of the window.
As central banks now rush to raise rates to cope with high levels of inflation, the game has changed. We are moving from whack-a-mole to a game of chess. Investors face a more strategic, adversarial challenge, in which the opponents are the central banks.
For now, central bankers’ priority is not to support markets, but to quell inflation on "Main Street" – or the “High Street” if like me you’re in the UK. This means we need to find a new equilibrium for valuations against a backdrop where the disinflationary maps of the past might not work in the future.
The good news is that valuations have improved on many metrics. Our fixed income investors in particular now see value in the level of bond yields after a torrid period for bond markets in which yields have surged (prices fall as yields rise).
For our multi-asset team, this is more of a relative assessment. Certainly, bonds are less vulnerable to the risk of recession than equities, where we believe that uncertainty around earnings is still not adequately reflected in valuations.
Our quantitative models that assess where we are in the economic cycle (to which there are four stages – recovery, expansion, slowdown and recession) are pointing to a shift into the "slowdown" phase, when earnings expectations are disappointed. This is typically the most challenging phase of the cycle for equities and so we remain underweight.
Recognising that growth risks are increasing, the multi-asset team has also closed its overweight position in commodities due to concerns about demand destruction in the energy sector.
Within our equities exposure the multi-asset team continues to have a bias towards value as a style.
Lastly, Rory Bateman (who leads the Investment Division with me and is our Global Head of Equities) and I were discussing what we’ve learnt from our experience of previous bear markets.
Firstly, as valuations adjust to a new equilibrium we will see strong bear market rallies, in this case particularly if inflation shows signs of peaking. Investors need to ensure their decision-making process is dynamic enough to cope with this or diversify their risk to avoid being whipsawed.
Secondly, the best valuation opportunities tend to emerge in recessions. So as the growth picture darkens in the next few months, don’t get too bearish!
And finally, in volatile markets you are more likely to make expensive mistakes. Investors need to remain focused on their strategic plan, nurture the resilience of their team and avoid over-steering.
Hopefully by the time I come to write my next CIO Lens, we’ve stopped asking the question of “are we nearly there yet?” and can start asking: “where next?”.
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