How low can we go?
Like spectators of a holiday park limbo competition (although somewhat less jovially), participants watching global markets are wondering “how low can we go?”
My last update posed the question of whether the sell-off was overdone and since then the US stock market has ground lower with multiple failed bounce attempts. Naturally, the press is full of commentators predicting when that market will bottom, when and how deep the forthcoming recession will be, and how many jobs will need to be lost for inflation to be brought under control. On Monday 20th June, former US Treasury Secretary and closely followed economist, Larry Summers, predicted that the US needs several years of high unemployment to bring the highest inflation in 40 years under control. The human cost would be huge, if he is correct, with as many as 10 million jobs lost in the US alone.
But here’s the rub; no matter how persuasive any economist or investment guru’s arguments for what may, or may not, happen in the future, they are educated guesses and little more. The future is unknowable. If any of us knew the future then, with apologies for the glibness of what is to follow, we’d be retired on our own private island somewhere.
As professional investors, our job is to think about multiple potential future outcomes, ascertain which we believe is most likely but to ensure that client portfolios are sufficiently diversified with appropriate hedges in place should our view not pan out.
Why hasn’t diversification worked?
Many of you, our valued clients, will understandably be concerned about the fall in value of your portfolio this year. Regular readers will know that we firmly believe in the benefits of diversification over the long term. The fact of the matter is that 6 months can feel like an eternity in volatile and uncertain markets such as these but, in investment terms, it is but a fleeting moment.
The beginning of 2022 presented numerous headwinds for financial markets including stretched equity valuations, rapidly rising inflation, and war in Europe. The environment has been toxic for both bonds and equities, which have behaved similarly year to date. As investors clamoured to price in higher inflation and rising interest rates, the fixed income generated by bonds became relatively less attractive. This meant that their prices had to fall in order for the percentage income yield to rise (% yield = Income/Price). This is clearly demonstrated by the chart below which shows the yield on the 10yr UK Government Gilt over the past 2 years:
This trend of rising bond yields, and falling prices, has been seen around the world meaning that there have been very few places to hide this year. As the chart below shows, the main bond markets are all in deeply negative territory year to date:
In fact, cash and physical property have been two of the very few asset classes which have managed to stay in positive territory so far this year in nominal terms. If we were to include inflation then almost nothing, bar esoteric assets, has made a real (net of inflation) return.
Does diversification work?
The phenomenon of bonds behaving in a similar way to equities, i.e. being strongly correlated, is not unusual. Traditional portfolio construction techniques rely on appropriately weighting different asset types with weak or negative correlations. If correlations are negative, this means that the returns behave in the oppositive way.
This is logical. If one can successfully optimise the mix of asset types then the differing behaviours should smooth the investment journey, reducing the volatility of returns, resulting in lower lows and lower highs of “abnormal” returns.
But, as with most things, reality is somewhat more challenging than theory because the correlation of equities and bonds is fluid. Whilst the chart below is out of date, it demonstrates the point:
We believe that much like other periods in history, the current environment of falling bond prices and falling equity prices should pass. However, we may need to see the arrival of an economic recession to bring this relationship back to “normal”.
Bonds tend to do well at the start of a recession as investors flock to bonds’ relative safety, anticipating lower interest rates to stimulate economic growth (lower interest rates mean that the fixed interest from bonds becomes relatively more attractive and so prices rise).
Therefore, in my opinion, whilst bonds shouldn’t necessarily be thought of as drivers of returns, they can offer valuable portfolio protection in certain market conditions.
Where do we go from here?
We, as the custodians of your hard-earned capital, are deeply conscious that these could be worrying times for some.
I realise that our consistent message of “sit tight” may cause frustration but the team’s cumulative experience and numerous academic studies suggest that simply doing nothing is better described as being prepared for the inevitable recovery.
The chart below, from JP Morgan, shows that US bear markets can be deep and painful (bottom panel), but bull markets tend to be longer lived and more than recover losses incurred (top panel):
One can infer from this that by selling now, the opportunity cost might outweigh the psychological comfort as significant gains could be missed when the next bull market begins. Although, admittedly, no one knows when that will be.
Another useful chart, again from JP Morgan, which helps put market declines into perspective is below. This shows that the FTSE All Share has suffered an intra year decline every single year since 1986. The declines average 15.5% but the index ended the year in positive territory in 25 of those 36 years:
In other words, if you’d just sat tight and done nothing you’d have made money in 69.4% of the past 36 years. I don’t know about you, but those sound like reasonable odds to me.
Finally, as mentioned, we are highly aware that these are worrying times. Please reach out to your adviser or investment manager if you would like to discuss your portfolio further.
Until next time, stay well.