Opportunities in volatile markets

22 January 2019

Equity markets have bounced firmly at the beginning of the year, as investors have seemingly reassessed some of the substance behind a disastrous December for capital markets. Nonetheless, we see investors being best prepared for market anxiety to remain high for the foreseeable future - history teaches us as much about the latter phases of an economic cycle.

There can be little doubt that 2018 was tough. By the end of the year, the FTSE 100 Index was down by more than 10% compared to the start of the year, Germany’s Dax Index had slipped close to 18% and Japanese equities were around 11% lower over the same period. US equities fared slightly better, but the S&P 500 Index was still more than 6% down. And with emerging markets equities also down by more than 12%, there were no hiding places for stock market investors.

There are many reasons for this dismal performance from stocks. Some of the blame can be chalked up to 2017, a year characterised by stellar returns from almost every corner of the world’s capital markets. Some in the market may have been guilty of the sin of extrapolation. When global economic growth inevitably ceased to remain synchronised and central bankers and bond markets (similarly inevitably) became less friendly, stock markets suffered.

Still, while volatility may continue, the outlook for the global economy is more positive than it may appear, providing opportunities for investors. Certainly, this is not the time to panic – as ever, taking a long-term view should see investors rewarded for their bravery.

The year ahead

As we look to 2019, we of course cannot rule out a recession.  As we regularly point out, the causes of many past global recessions were not predictable ahead of time – oil shocks, wars and more generic swings in ‘animal spirits’ have been an unavoidable part of investing life. Many argue that part of the compensation we receive from financial assets accounts for these increasingly infrequent blights. Nonetheless, humility, and its investing equivalent, diversification are always appropriate as we regularly argue. The future will remain shrouded in mystery no matter how hard we squint.

For those looking for a more accessible example, think of your ability to know in advance the results of every game in the Premiership (football) for the weekend just gone. There are generally always a few, sometimes more, surprises. We may have a better chance however of guessing who might win the premiership title, based on the quality and size of the squad, spending power, recent track record and a range of other metrics.

So it loosely goes with investing. Here, the longer term tends to be more readily tethered to humankind’s relatively reliable ability to innovate. In the short run, the larger role played by confidence in the world economy will regularly make fools of us all.

In such a context, the strategic part of our investment portfolios, the part that delivers the majority of your returns over time, will continue to play to that long term theme. For medium risk portfolios, a slant towards stock markets and company ownership gives you exposure to the humankind’s aforementioned innate restlessness. On the other hand, the part of the portfolio that is designed to harvest any short term opportunities does not so much rest on an ability to see the future better than anyone else.

More it is about retaining a focus on analysing incoming data on the world economy as dispassionately and objectively as possible. When and if there are signs that others in the market are perhaps struggling to do the same, opportunities can arise.

Investment conclusion

Even after the bounce back in sentiment that we have seen so far this year, we suspect that investors in aggregate are a little too cautious on the prospects for global growth and inflation in the quarters ahead. We are not expecting a sharp bounce back in economic activity from the world this year. The US fiscal surge has ebbed as expected and the ongoing government shutdown is further taxing quarterly growth.

Meanwhile, the Chinese economy should find a lower trend, helpfully a little closer to its potential growth rate. The clouds do continue to darken over the UK a little, but this is of much less importance to the world’s (even the UK’s) capital markets as we regularly point out. Overall, our indicators are still not yet telling us that a recession is on the horizon.

As a result, our tactical portfolio remains slanted in the opposite direction to this still cautious consensus. We own a little more equity than our benchmark and less high quality bonds. Overall, our tactical portfolio is significantly less risky than say at the beginning of 2016, which incidentally was the last time the downslope of an inventory cycle became mixed up with the dark descent into recession.

Slumping sentiment had forced a more profound dislocation from fundamental reality back then in our opinion. The opportunity now is more moderate and the cycle is a little older this time around, as our more muted positioning implies.

Taking a more active approach

Rapid swings in asset prices can unnerve investors, but volatility can also present opportunities for those who can maintain their composure and focus on a longer-term time horizon.

Still, some investors may need to change tack. Volatile markets can support an active approach to investing that focuses on actively-managed portfolios over a passive approach using index trackers. That’s because in volatile markets, there can be greater disparity in the performance of companies even within the same sector, providing opportunities for fund managers to look for value as a way to generate returns above benchmarks. Their stock picking skills rise to the fore in this environment.

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