Monthly Digest: Back to school, market lessons

The cacophony seems louder than ever. Behaviour is getting unruly, and it’s time for the headmaster to call the class to order: a brief look back at summer, then it’s time to lay out the curriculum for the term ahead. 

Despite scary headlines, August was very respectable for markets and balanced portfolios. Concerns persist - from geopolitics to interest rates. But companies continue to deliver strong earnings, leaving investors to balance resilient fundamentals against persistent risks. 

In the last Monthly Digest: Waiting for God(ot), we covered four unresolved themes: the Iran War, AI, central bank policy, and the UK’s public finances. If anything, the waters have become murkier. Even so, investors have taken solace from an encouraging second-quarter company results season and purchasing manager surveys suggesting the global economy is navigating these challenges. 

(Lack of) Situational Awareness

At the beginning of August, markets were digesting the rapid loss of value of the hedge fund Situational Awareness. We read this as an isolated incident involving a relatively inexperienced fund manager with extreme views on AI who became overextended and was forced to liquidate his positions; so it proved. There was some contagion into the more speculative corners of Asian markets, but it was contained, helped by Citadel (a much bigger hedge fund), which mopped up the spillage. Citadel has already booked its multi-billion-dollar profits on the trade and moved on. 

Such incidents are keeping investors on edge. Bank of England Governor Andrew Bailey recently warned that a sharp fall in the value of AI-related companies could trigger a market sell-off -  an easy line for alarming headlines. 

But context matters. Bailey chairs the Bank’s Financial Stability Board, whose job is to flag market risks, not predict imminent crises. After missing many warning signs ahead of the global financial crisis in 2008, regulators are understandably determined not to be caught out again.

It is worth reiterating the warning by Charlie Munger, the late confederate of famed investor Warren Buffett, that (financial) leverage is one reason why “a smart person can go broke” (with the others being “liquor” and “ladies”). That’s not to say that debt should be avoided at all costs. Indeed, the world would be a less developed place if savers were unwilling to lend to innovators and entrepreneurs who could then create new productive assets. Companies can optimise their balance sheets to blend more expensive equity capital with debt to maximise returns for shareholders. But when investing, we avoid highly leveraged instruments. The potential upside is outweighed by the risk that volatility forces untimely selling or, worse, a total loss of capital.

A welcome dip

This extraordinarily hot summer has made any dip in cool waters a welcome relief. The latest AI-related sell-off gave investors another chance to ‘buy the dip’, sending global equity indices to new all-time highs. We recognise that, at some point, there will be a dip not worth buying. Even so, there’s no imminent catalyst for a major setback in economic growth or profits. 

If trouble arises, it will probably result from a geopolitical mistake or a bond-market riot. In geopolitics, the US, Iran and Russia make for difficult analysis, but game theory still suggests severe escalation is a lower-probability outcome, even if the impact could be high.

Persistently high oil prices from Middle East supply disruption are not fully baked into expectations. Bank of America’s August Fund Manager Survey found only 1% of respondents expect the price of a barrel of oil to be over $100 by the end of the year (versus $95 for the Brent crude international benchmark at the time of writing). The consensus is that US President Donald Trump wants to declare some sort of victory before the 3 November mid-term Congressional elections, using escalation to pressure Iran to agree to acceptable terms. But Iran knows this and will also seek to extract the best possible terms for itself. 

Weapon of mass disruption

The number of vessels passing on the average day through Strait of Hormuz remains much lower than before the Iran War, as Iran uses its power to create shipping chaos as leverage.

The Streisand Effect

In 2003, the singer and actor Barbara Streisand tried to remove an aerial image of her Malibu home from the internet. Captured for a documentary about Californian coastal erosion, it had been seen by only a handful of people interested in the subject. Her high-profile lawsuit counterintuitively drew attention to it, and viewership rocketed.

The US Treasury Secretary, Scott Bessent, seems to have made a similar blunder, albeit in the rather more important US bond market. Yields had been rising, but panic only began when the US joined Japan to support the yen. In theory, there was nothing untoward in that; in practice, there was. US yen purchases were funded from euro reserves, while Japan was offered dollar liquidity through the US’s central bank, the Federal Reserve. This allowed Japan’s Ministry of Finance to access dollars (to buy yen) without having to sell any of its US Treasuries.

Bessent then went further, announcing buybacks of longer-dated bonds funded by issuing short-term government debt. The purpose was to stop the rot in Treasuries, but the effect was to highlight the precarious state of US public finances. Interest payments and entitlements already absorb all US government revenue, leaving discretionary spending to be funded through deficits running at around 6% of GDP. 

The icing on the cake was a suggestion that the Treasury General Account (TGA) - effectively the government’s current account at the Fed – could be used to buy back bonds.  It’s meant for day-to-day spending and liquidity shocks, not as a slush fund to suppress yields.

Restless traders, with most of the results season behind them and no new AI themes to chase, alighted on bonds, and a fresh round of selling began. The US was not alone. Four other targets with fiscal problems are in investors’ sights: the US, Japan, the UK and France. 

We’ve avoided longer-dated government bonds for precisely these reasons, but we may finally be approaching the point where investors force politicians to address structural fiscal deficits. And while bonds offered no shelter from weaker equities in 2022, it’s worth remembering that the UK 10-year gilt bottomed at just 0.07%, compared with 5.2% today. 

Conclusion: More heat than light 

The current market environment remains challenging. The old mantra of ‘time in the market’ is better than ‘timing the market’ has again proved helpful. So too has diversification, which has mitigated some of this year’s volatility. We hope the ‘time in the market’ mantra has encouraged investors to stay the course. 

As ever, energy is devoted to every passing piece of news, fed by a bottomless repository for information and commentary demanding daily replenishment. That, alongside current market structures, exaggerates short-term price swings. Like Odysseus in this summer’s blockbuster hit movie, we sometimes must tie ourselves to the mast and resist the siren calls. At the same time, we remain vigilant for the rocks and whirlpools lurking close to our path.