Reflections of the CIO

After a very weak end to the third quarter, markets duly staged a mini recovery during the month of October. As with the preceding selloff, the recovery was broadly based across geographies and asset classes, with the US stock market leading the charge and ending the period up nearly +9%. The principal reasons for the recovery have a lot to do with the extent of the market falls in prior months. Global equity markets for example, were down nearly -30% year to date before the recovery began in the second week of October. By that stage we were undoubtedly reaching a point of ‘seller exhaustion’, particularly as many investors tend to concentrate their selling towards the quarter end in September, leaving the coast clear for some form of recovery once this process is complete. A largely uneventful corporate earnings season also helped to steady the mood, although it was also apparent that any company disappointing on earnings or outlook, would be punished severely (Meta/Facebook falling -30% post results being the most prominent of the casualties in this arena).

Sentiment remains very weak, and liquidity is poor, both at the market level and in the financial system as a whole. Investors’ time horizons appear to have shrunk to fit alongside the next monthly inflation datapoint, with sharp price swings depending on what the actual reading is and the perceived future responses of central banks. On that note, it is worth pointing out that interest rate policy has tightened very considerably across the developed world in a very short space of time. The futures markets have priced in interest rate rises well into next year, as investors accept that squeezing inflation down will take a sustained effort, which central bankers are serious about delivering. The journey to this realisation over the course of the year has been painful, with very few assets outside of oil related commodities showing positive returns. The big question to us at this point is how much of the bad news is now ‘in the price’ or, to put it another way, just when should we shift our focus towards risk taking and away from risk avoiding.

For us the answer is not quite yet, but most likely soon. For the majority of this year we have actively chosen to not use up the entire risk budget available for each particular client portfolio, and we won’t be changing that stance in the near term. There are several reasons behind this decision, with the main one being that we continue to feel that we are still very early into expected economic downturns, and we don’t yet have a good understanding  about how long this could last, nor how severe the effects could be. There are also ‘tail risks’ due to the war in Ukraine and in particular from China, which is still struggling to get on top of a very large property market downturn. The interest rate cycle also has further to run and to date there has been a remarkable resilience to the increases so far, with few large corporate or government casualties (although the UK did briefly manage to put the gilt market up as a candidate only a few weeks ago). We would prefer to wait a little longer to form a better view on just how these events will play out, before feeling comfortable enough to start adding to risk in a meaningful way.

At the same time we also think that we are passing through the period of greatest risk in markets and that more and more investment opportunities are presenting themselves. There is a growing body of real world evidence that inflationary pressures have indeed peaked, which in time will pave the way for a pause in interest rate rises, presaging a reduction thereafter. As previously mentioned, valuations already discount a recession in large parts of the global equity market, and the flip side of rising interest rates is that some investments which were unattractive for long periods now offer acceptable returns for their risks (e.g. shorter maturity government bonds). We have therefore shuffled some positions in portfolios to take advantage of these dislocations, but without dialling up the amount of risk we want to take overall.

In practical terms, some equity positions have been recycled into corporate bonds, where yields in the 6-9% range are attractive. We have added to Japanese Yen exposures, attracted by long run discounts to fair value in excess of 30%. Geographically, we have moved away from equities in the Asian and Emerging Markets arenas, fearing the deep rooted problems in China will keep a lid on the regions performance. Similarly, we think it is still too early to start picking up UK risk assets –in the form of equities or sterling – given that peak economic stress is yet to impact. We have however, added some UK government bonds to lower risk portfolios post the recent sell off, as they not only should offer some protection if the economy worsens beyond current expectations, but also carry decent yields for the first time in many years.

Overall, we feel that as we enter the early part of next year, the outlook should be a little clearer in terms of where inflation, growth and profit trends will ultimately head. We have travelled very far already in pricing in the shift to a new investment regime of higher inflation and higher interest rates, a journey which has been difficult. The best asset mix for this ‘new’ investment world is not yet crystal clear, but it is much clearer than it was. Consequently, we have begun the process of gently adjusting underlying portfolio investments and if trends do pan out as we expect, this pace of adjustment will accelerate in the first part of next year.