One of the best-known mantras in investing is ‘buy low and sell high’ and whilst this is an uncontroversial strategy it proves surprisingly difficult in practice. The first challenge is to judge when a high or low is occurring, as it is only with hindsight that such moments become obvious. The second is psychological. Stock markets are forward looking – usually prejudging economic out-turns by 12-18 months, so even if one can identify a low point, it rarely feels like it at the time. Investing when everyone else is fearful feels incredibly uncomfortable even for seasoned investors, however markets tend to bottom out early on in any period of pain being felt in the real economy and have often bounced back long before the pain is over. The Covid crash and ‘V shaped’ recovery in March 2020 was a good example of this. The great temptation is to sell and to wait until things feel more comfortable before recommitting, but in so doing the majority of the upside is usually missed.
At present the world, and the UK in particular, feels pretty depressing – inflation is at or near double digits in most developed economies, there is a war on the borders of Europe which may yet escalate, the Chinese growth engine is stalling due mainly to its repressive Covid strategy, and economic recession is either very likely or inevitable in many of the larger economies. From a UK perspective our current political situation is only adding to the pain and our currency (representing the attractiveness of the UK as place to lend to or invest in) has taken a battering. None of this feels comfortable.
For those currently invested we are acutely aware of how unpleasant it feels to see valuations falling and the temptation is to extrapolate a downward trend and assume that it will continue indefinitely. The reassuring news is that it does not – or at least has not historically, even through recessions, world wars and pandemics.
At times like this, it is important to try to stand back from the noise and ask the objective question: as long-term investors, do we think markets will recover from current levels and be meaningfully higher on a reasonable time scale, say 5 or 10 years from now? That is a more useful question. In the long run of history, a 5-year time horizon results in a positive return from equity markets 92% of the time. Over ten years the occurrences of a positive return have been 97%*. The price that must unfortunately be paid for superior long-term returns is the discomfort of volatility or the short-term fluctuation in markets. The traditional defence against volatility is diversification; this works well in the medium term, although at times of high stress most assets tend to fall in tandem, as they have so far this year.
We try to take a pragmatic view: markets have fallen, and we have done our best to protect against the worst of the falls by limiting exposure to the investments that seemed most expensive and high risk to us, holding higher than normal cash balances and allocating more to areas that were more defensive when things looked rosier last year. This has not protected portfolios completely but has helped and every pound saved on the way down leaves investors’ portfolios in a better position to benefit from the recovery when it comes.
Interest Rates & Inflation
Inflation has risen to levels not seen for several decades and most central banks are raising interest rates to combat its effects. This usually works but is a painful process, particularly for those with mortgages but also for companies with debt whose cost of borrowing increases. The consequence of both is that share prices fall – customers have less to spend, and companies must use more of their profits to service borrowing rather than, for example, paying out dividends or reinvesting for growth.
The media focus is currently on rate rises and inflation, however it is important to remember that interest rates are cyclical, and at some point in the near future central banks will start to see inflation coming under control – when that happens rate rises will cease and faced with slowing or contracting economies rate cuts will become more likely. In anticipation of that event, forward looking markets should start to rally – potentially at the first sign that the cycle has turned. Guessing the timing is impossible but staying invested, now much of the pain has already been suffered, affords the best chance of capturing the upside when it comes.
Equity Markets and Currency effects
Last week the pound fell to its lowest level against the US dollar since decimalization. Whilst there were some good reasons for this, such extreme valuations rarely hold for long, and currencies tend to revert to mean over the medium term. It seems to us that whilst the UK is being judged ‘un-investable’ by many global investors this presents an opportunity. The UK market has some great global companies now on cheap valuations compared to history and to their peers listed on overseas markets – if one has the patience and courage to invest in them this could be an opportunity to buy low.
Conversely the US dollar, as the world’s safe haven currency, is looking historically expensive. With the Fed ahead of most central banks in raising interest rates and the US economy generally more insulated than its European peers, it is likely that the US economy will experience a lighter recession than most and might avoid it all together. That said, the risk is that UK investors could benefit from a rebounding US stock market but lose just as much by a correction in currency if/when the Fed starts cutting interest rates. We are currently considering switching to GBP currency hedged units in US and Global funds as a possible way to benefit from this scenario.
A weakening US dollar should also prove helpful to developing markets. We have avoided Russia and Eastern Europe and remain cautious of China for political reasons, but other markets, particularly in Asia, are beginning to look attractive. Favourable demographics (younger populations) and the restoration of global supply chains provide compelling reasons to include at least some exposure to these markets in most portfolios on a medium to long term view.
Corporate and Government Bonds
We have been very underweight in this sector for some time believing that Quantitative Easing would at some point lead to inflation which is bad for bonds. This year that has proved a good call but has taken much longer than we thought to happen. UK Government bonds (normally a safe asset) have fallen by c.38% this year**. The pain may not yet be over, but at some point prices will fall to the level at which the income these investments offer will look attractive again. Bonds tend to do well when interest rates fall so we are keeping a close eye on this sector looking for attractive opportunities.
Alternatives and Targeted Absolute Return funds
We have in recent years preferred these sectors to Bonds and have had a reasonably high exposure to Infrastructure, Renewable Energy and Specialist Property. These have proved a good defensive diversifier for much of this year; most of these funds have a measure of inflation protection built in to returns so have proved quite resilient. They are not immune to volatility but in combination with well managed absolute return funds have provided an area of safety and a decent income in this difficult period. We continue to hold them for this reason.
Cash
It is at long last possible to be paid a return for cash on deposit – the best 2-year deposit rates we have seen are currently offering over 4%. Whilst this is welcome news for savers and helpful for emergency funds, these returns are illusory. As long as rates are lower than the rate of inflation cash is actually moving backwards – we continue to hold cash in portfolios for protection and to provide liquidity, but it is still not a good long-term investment.
In summary
We know this is a very trying time to be an investor, people are fearful and there is not much in the news to be hopeful about. However, we continue to believe in the ability of both markets and economies to revive and reinvent themselves. Precise market timing is impossible, but we have confidence that patience and time will resolve the current issues. We are not foolish enough to try to call the bottom of the market, but it seems to us that after three rather miserable quarters, we are a lot closer to the bottom than the top. As uncomfortable as it is to do, we will try to use this as an opportunity to buy low and trust that we will have another opportunity to sell high in the not too distant future!
This note is intended as a general market update and should not be regarded as specific advice or treated as a recommendation to invest in any particular fund or asset class. Stock market investments can fall as well as rise. If you would like to discuss the implications for your own portfolio, please do get in touch.
*MSCI World rolling 5 and 10 year returns since 1975. FE Analytics 04/10/2022
**10 Year UK Conventional Gilt TR. FE Analytics 04/10/2022