The table below compares, by Asset Class and Style, the YTD and Quarterly performance over Q3 and Q2 respectively.
The deterioration, in market conditions, was painful. Every asset class worsened over the quarter resulting in a bigger YTD loss. Value worsened the least. However, even more interesting – and something which is always overlooked by investors – is the effect of currency (FX). The table summarises index returns depending onthe investors’ base FX.
FX moves have been alarming. If ever there was a time to use FX weakness as a hedging (i.e. protective) tool - it has been the year.
What the above FX table shows is the effect of FX translations on portfolios, if you are a GB£ investor who invests in the MSCI World index. The latter derives a substantial part (in excess of 50%) of its revenues from US-based firms. A declining GB£ means the US$ revenues of those firms – when converted to GB£ - return a higher figure. Therefore, A GB£ investor endured a return of -5.4% Contrast this with a US$ investor who suffered a return of -9.3%.
So, what has happened over the Quarter to explain the continuing decline in markets?
Basically, it has been more of the same we witnessed in Q2 – but on steroids:
the continuing inability of Central Banks (CBs) to get inflation under control
the spreading effects of rising energy cost across the wider spectrum
the continuing geo-political debacle over Russia-Ukraine – even though it quietened a little over the summer period
the rise in Bond yields as both inflation but tightening monetary conditions take their toll, especially in the US with the Fed determined to reverse QE (= QT)
climbing fiscal deficits across the globe but especially in Europe which are stretching debt burdens and the ability of those governments to service their debts
Recession fears have gripped markets because they fear CBs will overcook interest rate hikes. This is understandable when we look at the language coming out of the US Fed. The voting members are quite divided in their views. By year end, the expectation is Fed rates at 4.6%.
Mortgage rates are rising fast. As of today, the 30y fixed rate mortgage is over 7%. The UK has endured a torrid time with the new leader and her finance minister rolling the dice over the economy and trying to pull unfunded budgets out of the hat – much to the distaste of markets which sent bond yields soaring until the BoE could calm things down.
Q4 Outlook and Portfolio Positioning
The last couple of Quarters have undoubtedly been turbulent. Markets and Investors have been caught by surprise primarily because of the sharp spike in inflation induced by the unforeseen Ukraine war. Up to this point, there was still some sense of order and portfolios were generally equipped to deal with the inflationary forces in the system. Ukraine changed all that by choking supply lines even further, driving up energy prices sharply and resulting in higher food and manufacturing costs. Generally, markets can handle gradual change. What they struggle with is sharp, sudden change – and that is exactly where we find ourselves. They have still not come to terms with the way forward because there are very few who know how to handle inflation.
However, this is where the worlds of Macro and Investing diverge! Despite all the doom and gloom expressed in markets, we are finding interesting, new & innovative investment opportunities which provide effective ways to skew the Risk / Return spectrum. It does mean looking and thinking out of the box, which isn't something that most of us find a comfortable thing to do.
What should investors make of all this?
Cash (as in pure cash), still pays nothing. Taking inflation at or around 9.00% means you are locking in a loss of -9.00% pa in real terms. So, inaction guarantees you a loss of -9.00% pa no matter what. However, today’s Money Market funds are paying a coupon once again ranging from 3% (US$) and 2% (GB£). If your 3m to 6m outlook on credit is sombre, this is an alternative form of fixed income. With Money Market funds, (1) you are finally earning something and (2) it’s a way of reducing credit risk if one is uncomfortable with central bank policy risk and further rate hiking cycles. The main risk to credit is duration (i.e. the longer the maturity, the greater the sensitivity to rate moves). It all helps in risk mitigation.
The US$ continues to outclass any other currency and this is unlikely to abate any time soon. The forces driving the US$ are not just around flight to safety. They are economic (consumption, balance sheet shrinkage and fiscal deficit reduction). They are also technical – foreign flows into the US$ for higher, attractive yields backed by a stable economy. In what is currently a “Risk-Off” environment, one must watch the non-US$ level of investment exposure from the US$ source of funding. As the US$ rises, the underlying investments will be adversely impacted.
Contrast this with GB£ and / or €. These currencies have collapsed against the US$ for very idiosyncratic reasons; other non-US$ currencies (e.g. EMFX) have fallen for systematic (market) reasons. This situation gives rise to the opposite effect – they provide a useful portfolio hedge (e.g. if your GBP investment is invested into US$ assets, a falling GB£ will mean you get more back in GB£). In a nutshell, a falling currency has its advantage – it can serve as a hedge.
Nothing beats the adage that you need to be in for the long term. As markets continue to fall, value continues to be created. There is no substitute for quality names – and neither is there a shortage of takers. As the first chart above demonstrates, Value was little changed from Q2 to Q3. PE Ratios are falling (i.e. value is rising). The MSCI World Index is around 14X P/E, MSCI USA down a touch at 16.3X (it is one of the few countries where you can still find some level of growth), MSCI Japan is on 12X, MSCI EM is on 10.5X while MSCI Developed Europe on less than 11X. To be clear, cheap can – and probably will – continue to get cheaper. But by averaging in steadily, you are reducing your overall entry cost which, in turn, helps change the asymmetric risk/return profile of a portfolio.
I referenced the need to look outside the box. Alternatives, as an asset class, is something many investors have shied away from primarily from a lack of understanding. They are a highly effective way of changing the risk profile of a portfolio be it through Variable Exposure (Long/short strategies) and Market Neutral strategies (equities and fixed income). They have been out of favour for a while – they are starting to make a comeback given the new environment we find ourselves in.
Last, but not least, to reinforce the importance of quality names to invest in. These have longevity, pricing power and scale in what are persistent inflationary times.