Reflections of the CIO…

This month’s asset allocation meeting was a unique one in the careers of your Saltus managers, entirely down to the fact that the number and breadth of the issues we had to consider was so broad and diverse. Complexity in the investment world is nothing new, but what is new today is the sheer number of variables which can significantly influence market outcomes, often in very unpredictable ways. A change in the choice of words by a politician or a central banker can easily move stocks, bonds, commodities and currencies simultaneously across the globe. A few tenths of a percent difference in an economic report could similarly cause immediate ripples far beyond the shores where the data was gathered. The investment world of summer 2022, really does feel unusually complex, requiring careful positioning to absorb any shocks and to exploit any opportunities.

We think the reason for this skittishness is the confluence of well-known financial imbalances (high debt, high inflation, rapidly changing monetary policy) with the global issues of war, famine and plague, in marketplaces which are low on confidence and high on structural fragility.

The roots of this fragility lie in the banking sector reforms introduced after the great financial crash of 2008, which pushed banks to beef up their capital reserves, rather than deploy said capital into making markets for investors. As this source of liquidity declined, markets became inherently more brittle, lacking the depth they once had, and which managers had become used to. Concurrent with this change we have also seen the stellar rise of ‘rules based’ investment strategies (e.g. tracker funds, algorithmic or high frequency trading hedge funds) across all asset classes. In equities, for example, the rise of the tracker over the last decade has resulted in an eye watering swing of c. $4.5tr in assets away from actively managed mutual funds towards passives. These ‘rules based’ strategies usually act to amplify market moves, as they tend to follow momentum up or down and place trades effectively on auto pilot, with limited human intervention.

If we layer the multitude of current macro-economic, political and societal themes on top of structurally brittle asset markets, where short term movements are dominated by ‘machines’, then it becomes easier to see why a small change in any one variable can have a speedy, large and hard to foresee impact. And yet for all the complexity and skittishness, summer 2022 is also a period where the number of portfolio tools and opportunities your managers have at their disposal has also increased substantially. This means that although our asset allocation meeting was long and detailed, it was also one where we felt we could express our views effectively in portfolios and retain high confidence that they will continue to do what they are meant to be doing.

There are several good examples of ‘new’ investment tools that we are currently using and one ‘old’ one that has made a timely re-emergence. Factor investing and the use of option or volatility strategies are two of the more prominent ‘new’ strategies which feature across our client portfolios. The former allows us to fine tune our equity weightings to factors better suited to the current environment, such as exposure to larger and higher quality companies. The volatility exposures work best in convertible bond and interest rate trading strategies, where it doesn’t matter as much which direction prices move in, so long as they move, increasing the value of the options embedded in these securities or held directly. The fact that cash and cash like instruments now have positive returns after so long carrying zero or even negative interest rates, pushes this simplest of portfolio diversifiers back onto the agenda. Cash allocations were always an active decision, now they are an active decision with a positive return.

With the availability of these investment tools, we think we can construct portfolios more nuanced in their exposures and able to better reflect our central case. We note how global markets currently have very short time horizons and have become fixated on monthly US inflation figures and the potential for a growth slowdown to morph into a recession of unknown severity. Offsetting this are the sharp adjustments to valuations and the income and employment gains that cushion the effect of rising prices and keep underlying positive growth trends intact. Our core view remains that the post Covid recovery is dented but not derailed. However, we also know that given the number of other important, competing factors, it is a view best expressed by dialling back the amount of risk taken for each risk band a little, and increasing overall portfolio liquidity. We don’t feel we need to de-risk substantially because we don’t feel the investment world is ending. We do think this period over summer and into autumn will probably be the peak in ‘bad news’ for several key issues, but given that we have the ability to park up a little and wait to see how events unfold, then we feel it would be wise to do this now.

Perversely, when the outlook becomes more complex, portfolio decisions often become a little easier. When conviction is hard to come by, we wait until it arrives, not feeling any peer or benchmark pressure to keep exposures when the investment case weakens. We know it’s better to concentrate on ensuring the diversification and risk controls which we want to have in place, are actually in place. The plethora of old and new strategies available to us means that we have the tools that are up to the job of dealing with the future, however that turns out.

On behalf of the Saltus Investment Committee, June 2022