We try to explain the world in fundamental terms – focusing on political and economic risk, and whether the circumstances are conducive to economic growth. This is most evident in our scenarios, in which we consider various paths along which the major economies might evolve over the following year. We then try to connect those narratives to outcomes for company profits, stockmarkets, bond markets and so on. This exercise can never produce more than a framework – something for basing decisions on. But it does help our decision-making if that framework bears some resemblance to the reality as the markets see it. Over the last year, our investment process has done a good job of predicting economic fundamentals but, at times, a poor job of anticipating market reactions.
The real difficulty is not in predicting whether capital markets will react or how they react, but by how much they will react. In July last year, the population of Greece voted to reject the bailout terms proposed by the European Commission, the International Monetary Fund and the European Central Bank (ECB). This was a major event since it was Greece’s first referendum since 1974. The bailout was rejected in all regions of Greece, as well as across all Greek constituencies, giving the Greek government an exceptionally strong mandate with which to repudiate its obligations. Bad news for the stability of the eurozone? You would think so, and so did the European stockmarket falling 9 per cent between the date of the announcement of the referendum and the vote to reject the bailout.
A month later, on 10/11 August, China’s central bank allowed its currency to depreciate by nearly 3 per cent against the US dollar. Bad news for the eurozone? Maybe tangentially, but maybe not: it was less than a year since the euro had itself depreciated by 20 per cent against the dollar as a direct result of ECB policies. Yet the European stockmarket reacted with extraordinary violence, promptly falling 16 per cent. Then, starting in late December, the Euro Stoxx 50 proceeded to fall 23 per cent over a couple of months without any particular, identifiable cause (though a host of reasons was suggested at the time). What’s really amazing is that at no point during this entire period was there any significant change in the outlook for the European economy, which started the period growing at about 1.5 per cent a year and ended it growing at the same pace. To put all this in other words: the goalposts keep moving – we sometimes know why, and we might be able predict the direction, but we will rarely know how fast they are moving.
More recently, the goalposts have moved again. This time the move has been to the upside though as the initial shock of Brexit gave way to an astonishing stockmarket rally leaving investors shell-shocked (but wealthier!). Rather than encouraging anti-European Union sentiment and anti-immigrant nationalism, or highlighting the European project’s weak foundations and its democratic deficit, Brexit has seemingly become a non-event. Meanwhile, markets have reacted with remarkable enthusiasm to (we think) a run of good American economic data. Fortunately we did anticipate a resumption of better economic growth in the US, meaning our funds were sufficiently invested in appropriate asset classes to enjoy some benefits. As a result, we were able to achieve good returns without running the risk of holding significant UK assets: the best performance has come from our investments in Asia, followed by those with exposure to the US economy. The UK stockmarket has also performed well over this period, but we are happy to avoid Brexit risk where we can. We all have plenty of Brexit exposure in our daily lives through our salaries and housing without using our savings to take more.
Our more defensive positions have also performed well lately. Government bonds in particular have beaten our expectations. It’s not often that both the most and the least risky parts of a portfolio perform well at the same time. Recently, we trimmed both, reducing our Asian stockmarket positions by 3 per cent and trimming our holdings of US Treasuries by 1 per cent (in Balanced portfolios). These Treasury holdings have been replaced by a defensive ‘option’ bought on the US stockmarket. This should give us better performance across most of our scenarios than other safe haven assets and, unlike them, it can be acquired cheaply. It is not a precise hedge for US equities – nor is it meant to be. Nor is it a sign that we think the world is about to end. While this option should certainly perform very well in a ‘tail-risk’ scenario, limiting portfolio declines of the kind that occurred in January, its role is principally to diversify the composition of defensive assets within the portfolios. With traditional safe havens looking extraordinarily expensive we continue to look for dependable, cost-effective alternatives.
We are currently waiting for economic data or company profits to justify the surge in stockmarkets and, while we wait, we’re happy to take some profits and judiciously find investments that help to limit potential losses for when the goalposts start to move again. How to deal with the problem of moving goalposts? The transmission of economic effects into market prices is affected by market structure, market automation, market participants, their views and the investment products they use to trade. In our research we are now trying to address the risk that this melting pot turns toxic. We should also consider the risk that it becomes excessively benign! Trying to time the stockmarket is a fool’s game - it is time itself that is the investor’s friend.
Chris Darbyshire is chief investment officer at 7IM
