Given market movements we have put together a short guide on some of our current thinking, and how we are responding, in our direct and multi-asset portfolios.
We’ve also provided some links to prior research, which would make this particular note (designed to be short and sharp) too long, but provide otherwise great background reading.
- Market conditions are volatile, but our portfolios are performing well. Our direct equities allocation has returned about 13% more than the benchmark over the last year. In other asset classes our defensive positioning and tilt away from high priced tech stocks has reduced the impact of the sell off on portfolios.
- Inflation, the proximate cause of volatility, is peaking, and will moderate.
- Tighter monetary policy, specifically driven by inflation, provides us with investment opportunities.
- Volatility, in general, provides us with investment opportunities, of which we are taking advantage.
For those looking for an additional primer on
- bond movements, see here.
- markets, see here and here.
- growth stocks, see here and here.
- inflation, see here.
Clients who are logged in will see full details of the portfolio performance below.
What to expect?
Inflation is high, and will likely remain generally high for at least the next few months, even as some of the month on month pressures alleviate. By the end of the year, headline inflation should be moving back towards 4%. Still high, but not destructively so.
Why expect that?
Ultimately, we think that central banks are 100% able to control inflation, through monetary policy. The graph below shows that indeed, the Fed is responding to higher CPI, by tightening interest rates (higher 2 year yields, below, a proxy of near term monetary policy) which feeds through into interest rates right across the spectrum (see 10yr yields, and corporate borrowing costs, such as the BBB spread, and real yields). That is causing expected inflation, proxied by 10yr BEs (breakeven inflation) to moderate, and is causing the US dollar (TWD, trade weighted dollar) to increase, which puts downward pressure on inflation by curbing economic activity, specifically, reducing the competitiveness of exports and moderating housing investment.
What impact does that have?
The tighter policy causes risky assets, like equities, commodities, property to sell-off. Government bonds have also declined, in line with the higher yields.
Whilst it might not be pleasant, from an investor’s perspective, there can be no doubt about the combined power of monetary and fiscal policy.
Adding in the past 12 days’ worth of declining asset prices, our multi-asset portfolios will be down in the order of 4-6% from their peaks. Below, we will describe how we are responding.
We have, over the past couple of days, added to our international equity exposures. This was a small trade, effectively buying stocks that have an improved forward-looking return given the sell-off.
This purchase adds to our relatively recent additions to European and UK equities, which sold off in the immediate aftermath of the Ukraine-Russia conflict. We added to both Japanese equity markets and emerging market equities, after similarly sizeable falls, albeit driven by different reasons (Japan, to increase our yen exposure, EM, after material intervention by the Chinese government to support markets).
These are modest trades, around 4% of the portfolio, but are done at very attractive prices, and given the long run nature of the portfolio, should aid in our efforts to compound and grow wealth over time.
We should also mention that we have quite material exposures to value, as an investment style, within equities, and these strategies are much less at risk in the current sell-off, which is more about unrealistically high expectations embedded in growth stocks.
We have, over the past quarter, and as recently as last week, added to our fixed income holdings. For over 2 years the forward looking returns to bonds had been unattractive, now, however, at 3.5% (for the Australian 10 year treasury bond) we think we are finally fairly compensated, and have moved overweight fixed income for the first time in years.
We see bonds as a good hedge against equity market risk, and now are largely through their repricing event (yields have moved from around 0.50% to 3.5%) and as such, we think they will recommence having a negative correlation to equities moving forwards.
Alternatives and cash
We’ve been quite overweight alternatives (hedge funds, listed and unlisted infrastructure, equity market neutral strategies) as a source of modestly positive yet uncorrelated sources of return. This allocation has worked very well, with our CTA/ARP strategies increasing in value, over the past quarter as markets fell steadily, and we are using these increased valuations to buy the (now better value) equities and bonds described above.
We’ve used our cash positions in the same way. We were quite overweight cash, and are progressively deploying it post sell-offs.
Property has sold off particularly hard, as higher interest rates negatively impact long duration debt-heavy assets like real estate, and their listed cousins (REITs, real estate investment trusts).
We’ve been underweight property, at the asset class level, for some time, having expected exactly this outcome. Like the capital deployments described above, we will probably seek to add some exposure, depending on how much further they decline.
However, it should be noted that our property exposures are generally very small, amounting to around 6-7% of a typical balanced portfolio. That’s good in that a) we don’t have much exposure to an asset class that has been selling off but b) means it won’t make an especially dramatic change to the overall portfolio even if we do add some additional weight as REIT markets correct further.
We’ve been well positioned ahead of time for this higher interest rate environment. We’ve added substantially to our insurance exposure (insurers generate higher income from technical reserves, referred to “returns to float”, as interest rates rise) and have good inflation passthroughs.
We’ve added to the banks, as the repriced mortgage book should expand net interest margins. We’ve got a substantial allocation to defensives (telecommunications, consumer staples) and, perhaps most importantly, are very underweight the tech and consumer discretionary sectors, where most of the sell-off is occurring, due to previously outrageously high valuations.
Not owning those “frothy” stocks has generated much of the positive relative performance described above.
There are good reasons to be constructive (bullish) on equities. a) they are now cheaper, but b) there is a plausible story in which central banks put their economies onto a more sustainable glide path for growth, successfully wringing excess inflation out of the system without inadvertently triggering a recession. That is a world in which inflation, interest rates, foreign exchange all track largely to expectation, as do earnings (corporate profits) and the ex-ante returns from risky assets are delivered.
There are good reasons to be bearish a) the Fed’s track record of generating a “soft landing” is not great, and b) there are risks like a slowing China (the “growth engine” of the world) or a wider militaristic spill-over (from the Ukraine-Russia conflict) or a commodity induced recession (oil price induced shock, of which we’ve had at least 4 since the 70s). Assuredly, in that environment, corporate profits would be lower and the returns on risky assets lower still.
As such, not having a material swing or tilt at any one thematic, region, style or strategy strikes us as prudent. A broad, well diversified set of exposures (asset and sub-asset classes) should continue to weather the uncertain landscape, much as it has always done (e.g. across the pandemic, across the debt crisis, across the China shock).
Relatedly, perhaps our penultimate message should be “there are many defensive assets within the portfolio, and should risk assets continue to sell-off, we will add to risk assets by selling those defensives”.
Relative to benchmarks, and relative to peers, our returns have been particularly good. Whilst we (or anyone) can’t guarantee anything about the future, we can at least suggest that whilst history doesn’t repeat, it certainly rhymes, and we have seen much of this before.
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This document is based on information available at the time of publishing, information which we believe is correct and any opinions, conclusions or forecasts are reasonably held or made as at the time of its compilation, but no warranty is made as to its accuracy, reliability or completeness. To the extent permitted by law, neither Aequitas nor any of its affiliates accept liability to any person for loss or damage arising from the use of the information herein.
Please note that past performance is not a reliable indicator of future performance.
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