05 September 2022
Investing involves the risk that your capital goes down as well as up; you may get back less than you invested. The commentary below is not intended as a recommendation for you to personally buy or sell any of the investments mentioned nor to take any investment action whatsoever.
Financial markets have continued to have a tough time. The summer rally, which appeared material, has fizzled and global stocks are almost back to the lows they hit in June.
The problem remains rising interest rates, which cause a company's share price to be worth less relative to its profits, all else being equal. This makes sense: if one can put their cash into something very safe, like a bank account, and get paid more for doing so then one should naturally pay less for something inherently riskier like an ownership stake in a company. So, as interest rates go up, the value of stocks - specifically the price of stocks relative to their underlying profits - go down. This can basically explain all that has happened so far this year with the stock market.
Compounding the problem is that supposedly safer investments within many investment strategies have proved to also be vulnerable to increasing interest rates. As such, many supposedly 'balanced' portfolios have suffered very significant declines because investments like corporate bonds and real estate have fallen sharply at the same time as their investments in stocks. This purported diversification has not been successful because it wasn't true diversification in the first place.
What Might Happen Next
Investors should be asking themselves two broad questions:
The first question is primarily driven by central bank activity which, in turn, will likely be primarily driven by inflation. Right now, the US Federal Reserve is taking pretty drastic measures that, all else being equal, push up interest rates. Perhaps most importantly for the near-term, it has just started accelerating the pace at which it sells the bonds that it owns (this is known as 'quantitative tightening', which is the reverse of the very market-friendly policy of 'quantitative easing'). Without getting too far into the weeds, this fairly aggressive action is, in my view, causing a significant reduction in risk appetite across markets and it is conceivable that this will continue for the next few months.
However, there are also signs that the Federal Reserve will soon be in a position to reduce its aggressiveness: if it is in gear 4 or 5 now, it is conceivable that it will reduce its pace to gear 2 or 1 by the end of the year. Why? Inflation is falling in the US and it may just fall enough towards the end of this year for the Fed to think that it has largely done its job in terms of 'getting inflation under control'.
So, for the first time in a long time, I am in a position where I think that interest rates (as expressed by bond yields, like the US 10 year yield) are as likely to fall as they are to rise. This change of view makes me more positive on riskier assets like stocks.
Turning to the second question of companies' profits, I am somewhat sanguine because recessions are a normal and healthy part of economic regeneration. In the near-term, the value of most companies decline but the higher-quality companies often emerge in better shape (e.g. with fewer competitors) as the economy rebounds and the stock market recovers. This could be classed as normal cyclical behaviour - although it might not feel like it at the time - and so long as investors don't sell during the weakness then they can reap the long-term rewards that come with an economic rebound.
What Are We Doing?
We are entering a dangerous period for financial markets where interest rates appear to continue to be climbing while the economy appears to be weakening. Although not my base case, I am cognisant that there is a significant risk that this leads to a serious panic in financial markets between now and Christmas.
If that occurs then some of the non-equity portions of our strategies will be sold and the funds re-deployed into riskier components of the markets (we have already done this to a very small extent within our 'balanced' strategy). Note that our 'non-equity' investments have performed relatively well this year as we have not owned the types of bonds, real estate and other investments that have been hit by rising interest rates, although we have bought some such investments recently.
More positively, it is reasonably likely that before Christmas the Federal Reserve signals that it will decrease the pace at which it is taking action. At the same time, it's reasonably likely that any oncoming recession is perceived by markets to be relatively mild, especially for higher quality companies. Such a scenario would likely be very positive for stocks and various other investments. In my view, this more positive outcome has become materially more likely even if there is going to be more wood to chop before we ultimately get there.
A Word on the UK
The above focuses on factors that primarily affect the global stock market rather than the UK specifically. Britain is in a much more precarious position than the US and certain other countries; this is evidenced by, among other factors, the significant decline in the value of the pound. However, it is important to recognise that our clients' portfolios are significantly more exposed to the global stock market than the UK stock market. This diversification has been a big benefit to our UK-based investors and it will very likely continue to be a benefit if the pound and other UK assets keep performing worse than the currencies and assets of the US and other countries.
Scott Tindle, CFA is the Founder & Director of Wealth Management at Tindle Wealth Management.
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