Why losing patience can be a costly error

Why losing patience can be a costly error

Investors will need no reminding that 2022 was one of the worst in living memory, with almost all mainstream assets delivering negative returns. But perhaps even more galling was that much of the damage to returns was caused by lower risk assets, the kind that are usually in place to protect investors. A case in point was UK Government Bonds, or gilts that fell by over 20%, wiping out the returns of the previous three years.

Financial markets went into 2023 with the hope that this year would be better and whilst stock markets did provide some cheer in the first half, led by the US stock market, things started to unravel in the third quarter. It seems that every time investors convince themselves that a bright dawn beckons, something conspires to undermine it. This can be frustrating and even demoralising, we understand that, and we completely echo that sentiment.

In the following pages we thought it would be useful to unpack a few of the major issues that have been unsettling markets, and which mean we have not yet seen the much anticipated ‘lift-off’. Moreover, we consider why some of these concerns might be overdone, and why we can legitimately point to a more optimistic tone to emerge before too long.

But before we start, it is worth a quick reminder of how investors tend to behave. Apologies in advance if you have seen this, or something similar, before but it is incredibly important, and a watchword for anybody invested in, or about to embark on, an investment solution.

We believe that investors, particularly those with experience, will know that asset prices rise, reach a crescendo, plateau and subsequently fall, before the whole cycle starts again. Whilst the catalyst for a change in the trajectory might be economic or political, the cycle is to a large part, governed by human behaviour. The catalyst can sometimes also be very hard to predict which is why ‘timing’ markets (getting in and out) often ends in disappointment.

The chart below is illustrative and not intended to represent the actual performance of any type of investment. We call it the ‘rollercoaster of investment emotions’ and it provides a very useful context for how investors often behave, which can sometimes be irrational. Though the graphic is presented as symmetrical, the ups and downs very rarely are, but the emotions tend to be pretty consistent.

Starting on the left-hand side, you can see upswings tend to be associated with feelings of hope and euphoria, often driven by momentum. Buyers clamber aboard on the, often mistaken, belief that prices will continue rising. But once this optimism fades, it can give way, first to denial (this fall is only temporary), then fear, panic and finally capitulation. This is where investors often conclude ‘maybe this type of investment just isn’t for me’ and throw in the towel.

This sentiment is invariably misplaced because the low point actually represents the point of maximum financial opportunity, but investors often get so utterly despondent, they show a propensity to sell, only to miss out on the subsequent revival. In our opinion, this is happening right now. Liquidity levels across the whole of the investment community are at their highest since the global financial crisis. People worry and eventually lose patience, with the natural response being to sell down their investments and grasp the safety of cash. This instinct should be resisted, and the recovery from the global financial crisis provides the perfect example of why. More on this later.

So let’s now consider some of the key areas that have impacted markets this year. The list is not exhaustive but represents the ones we feel to be most pertinent.

Interest rates

We are sorry to go all the way back to COVID again. It is a period most of us are trying hard to forget, but if we performed a ‘root-cause analysis’ for our current monetary policy, the pandemic would be the major culprit. During COVID, the world economy was shut-down and central banks printed money with gay abandon. We paid people to stay at home, producing nothing. Whilst undoubtedly the right thing to do for protecting lives, it created huge imbalances in the economy.

World economic activity collapsed but consumers were flush with cash. Fewer goods and services being produced matched with excess money supply could lead to only one outcome, inflation. In the previous decade, all major developed economies had got used to a world where there was no inflation to speak of, but suddenly the world had a huge inflation problem. The traditional way to deal with this was to jack up interest rates, and that is precisely what the monetary authorities around the world having been doing ever since. Rates in the UK and US for example have gone from virtually zero to over 5%.

There are a couple of issues to consider here. True, interest rates can be used to tamp down demand and so cool inflation. But there is a lag. Higher rates now, might not impact activity for up to 18 months, so ratcheting up rates relentlessly each month means there is no ‘time-out’ to assess how rate increases so far have worked. If rates are held too low, inflation remains a problem. If policy is too aggressive, central banks risk damaging the economy, leading to a recession. We will consider this in more detail shortly.

 Bond yields

Regular readers will know that we have been underweight bonds since well before COVID. We maintained that a 10-year treasury bond in the US, or its gilt (UK) equivalent offering a yield of 0.5% or less was simply too low. Our core belief was that yields would rise, which meant prices would fall. Our prognosis was absolutely correct, but what has surprised us (and most of the investment world to be fair) was the sheer ferocity with which bond yields have risen.

Bond yields are very sensitive to interest rates, meaning when interest rates rise, so too do bond yields, with a corresponding fall in the price. There are exceptions to this rule, but in terms of diagnosing why bonds have had such a difficult time, this is one of the key reasons. For things to improve, markets need to see evidence that interest rates have started to control inflation, that rates have peaked and there is a likelihood they can start to come back down.

Our opinion is that rates have started to cool the inflation picture and central banks will be acutely aware that keeping rates at punitive levels risks damaging the economy. As consumers, higher interest rates will start to hurt if they haven’t already. Anyone coming off a fixed rate mortgage now, is facing a cliff-face in terms of cost. Those looking to buy a car on finance will also be in for a shock, which is why the likes of VW, Mercedes and Tesla are all crying poverty.

But it is not just consumers facing increased costs. Any corporation looking to refinance debt, will be doing so at much higher rates than say 3 or 4 years ago. Central banks will be cognisant of this. If higher interest rates and bond yields is doing the job of cooling the economy, this takes the heavy-lifting away from central banks, and strongly suggests to us that rates could have peaked. Phillip Jefferson, Vice Chair of the Federal Reserve said as much at a recent press conference:

‘We are watching the tightening of financial conditions and the sharp increase in long-term real yields, and these developments are doing some of the hard work for us, and as such, we believe we have reached that fabled sufficiently restrictive level.’

The Fed is notoriously opaque in the language it uses, so in our opinion, this is the clearest signal yet that rates have peaked and any signal that rates will be on a downward path in 2024, would be further good news for bonds.

The probability of recession

The jury is still out. Some commentators are predicting a brief and shallow recession, others a ‘soft-landing’, where interest rates dowse inflation without major damage to the economy. But make no mistake, a soft landing can still feel like a major slowdown in economic activity. Until recently the economic picture in the US has been remarkably robust, driven by a buoyant consumer, backed by historically high levels of savings and a strong labour market. Put simply, if consumers have spare capital and they are not in fear of losing their jobs, they have a propensity to spend. This keeps the economy ticking over.

Recent evidence suggests that this might finally be about to turn. Savings rates which ballooned during COVID have started to normalise and average incomes in the US declined in 2022 for the third straight year, and the worst since 2010:

Bottom line is that the economic picture is weakening. Good news for inflation, and probably points to lower interest rates in 2024.

 Company earnings

The economy and the stock market are not the same, but there is a key dependency. Broadly speaking, economic prosperity feeds into company earnings and that is generally good for investors. But the relationship is not that straight-forward. Stock markets always anticipate what is likely to be happening in the economy 12 or 18 months ahead. Stock markets, particularly the S&P500 in the US started the year with gusto on the belief that recession might be averted, and interest rates would be on a downward path as early as this year.

The reversal in the third quarter represents the reality that company earnings are going to come under some pressure and an acceptance that rates would be higher for longer. There is also evidence that higher bond yields are tempting investors away from stocks, a fact also evidenced by historically high levels of liquidity amongst investors.

The other factor at play is concentration. The top few stocks dominate the S&P500 index. In the early part of the year, the US stock market was propelled higher by the ‘magnificent seven’ stocks – Apple, Amazon, Alphabet, Tesla, Nvidia, Microsoft and Meta. These companies alone account for 25% of the index. As you can see from the blue line on the chart below, the index had risen almost 20% by July, but applying an equal weight to all the 500 components of the S&P (white), shows a completely different story. It halves that gain to July and the index would actually be lower now than at the start of the year.

The ‘magnificent seven’ are all technology stocks and when these are in favour investors can rightly rejoice. Nvidia is up 180% so far this year. But these companies are highly sensitive to earnings disappointments. So much so that four companies alone (Meta, Tesla, Microsoft and Alphabet) have combined to trim nearly 10% of the entire S&P500 index since the July peak.

Some of these companies are sitting on ratings that could bring investors out in a cold sweat. We often think about company value in terms of a price earnings (PE) ratio. This is the number of years of earnings it would take an investor to earn back their share price if they bought today. Very crudely, the lower the better. The average for the S&P500 (excluding the top 10 stocks) is 17 times (or 17 years of earnings). The top 10 stocks sit on an average PE of 30. Nvidia trades on 97 times. That’s 97 years to earn your share price back. Fine if Nvidia keeps churning out exponential profit growth, but the shares would get punished if it doesn’t.

All we are saying here is that within one index, most of the risk sits within a handful of technology stocks. The other 490 is where the true value lies.

 Geopolitics

Without wishing to trivialise the devastating scenes we have witnessed in the Ukraine or Gaza/ Israel, events of this nature tend to have a short, sharp impact, but seldom a lasting one. Investors hate uncertainty so we often see capital flow to areas of perceived safety. Ironically bonds are usually a beneficiary of this, but the more powerful influence of inflation and interest rates have served to sideline would-be investors. Instead, cash, gold and the dollar have tended to act as safe-havens.

We do not see the situation in the middle east having a major influence on financial markets unless there is a prolonged interruption to oil supply or the conflict broadens out, for example if Iran is found to have had a major role in directing the incursion.

 The dollar

The ‘greenback’ tends to be the currency of choice when investors feel uncertain. The added attraction of the dollar at the moment is the high interest rate environment in the US which is sucking in capital. The world tends to struggle with prolonged dollar strength simply because much of the world’s debt is denominated in the currency. In our opinion, the significance of dollar strength is often overlooked by markets. The prospect of lower rates will likely relieve some of this pressure.

 Powers of recovery

The analogy of the ‘rollercoaster’ which we opened with is a poignant one and it is strikingly accurate. As liquidity levels have been rising, this strongly suggests we are at the ‘despondency’ or ‘depression’ markers, or more significantly the point of maximum financial opportunity. History suggests this is where investors often capitulate, and this is representative of what we are seeing.

Looking at previous downturns, this chart (source: Forbes) displays the S&P500 from 1926 to 2019. The first point to note is that bull markets, tend to be longer and on a grander scale than setbacks, though that is of little consolation when investors are being buffeted. Readers can also see that recovery when it arrives is often significant, with the decade after the global financial crisis seeing a stock market return of 450%. Of course, we cannot quantify the level and duration of recovery this time, nor can we pinpoint precisely when this will arrive, but there will be one and investors can only participate in it if they remain invested.

It is worth a quick note about smaller companies which are particularly sensitive to a downturn in economic activity. Additionally higher interest rates on the cost of their borrowing tends to be punitive. Smaller companies have had a tough time, but compared to their larger brethren, they have never been so cheap. A suitable parallel with what we are seeing now is what happened during the global financial crisis. In 2008 the sector fell 41%. In the following 5 years, it rebounded by a whopping 150%, with a 60% uplift alone in 2009. We understand patience wears thin, but recoveries of this magnitude are worth waiting for.

There remain uncertainties, but then in the financial world, there always are. We have been through a painful inflation shock, interest rates have gone from almost zero to upwards of 5% and this creates huge dislocations in financial markets. From reading the notes above, you will see that many of the issues restraining financial markets boil down to the rapid adjustment of sharply higher interest rates. This will not last forever.

We believe interest rates may well have peaked and could well be on a downward trajectory next year. This will be supportive for bonds and equities, particularly smaller companies. But markets won’t wait to see evidence of rate-cutting, they will anticipate it. Similarly, they will not wait around to see evidence that the economy and company earnings have bottomed-out, they will be quick to price in better times ahead.

Financial markets have always rewarded patience. And they will again.

Dr Andrew Mann

Investment Director