Weekly Digest: Looping back

The last few weeks have brought choppy market action: short, sharp moves but limited progress. It’s when we’re in the void between company reporting seasons that we remember traders are like sharks, which need to keep moving unless they suffocate, and so every news headline and central bank statement is analysed to death to wring out even the smallest available signal. Thankfully, we’re not in the short-term trading game, so we can afford to take a longer view, although we’re constantly monitoring the scene for incoming predators. 

The second round

Last week, I looked at the tug-of-war between rising interest rates and bond yields on the one hand, and powerful corporate earnings on the other. Rising rates are reducing valuations, while strong earnings provide support. The two are cancelling each other out, leaving equity markets range-bound but close to all-time highs. 

I concluded that a positive resolution of the Iran War, bringing lower energy prices, could trigger an upside breakout for equities. But we also need to consider what might go wrong. The most immediate threat is higher inflation, and the most probable cause is even more severe shortages of energy and refined products. The outcome is highly dependent upon President Trump, Iran’s religious and military leaders, and Russia’s President Putin, making the risks extremely difficult to assess and price into equity valuations. We’re not talking about mainstream politicians here. It’s about legacies, ideologies and an existential fight for survival. 

Our outlook remains informed by past research on geopolitical risks. Investors have generally benefited from not reacting too defensively to initially shocking events. But we acknowledge that some events can have more severe consequences, especially if they turn into long, drawn-out affairs. Both the Ukraine and the Iran Wars are heading that way. 

The world tends to be quite creative in adapting to supply shocks – sudden disruptions that reduce the availability of essential goods, such as energy or raw materials – which can be thought of as having ‘first-round’ effects (the immediate impact of a supply shock on prices and economic activity). Consumers can switch to alternative products or materials; shocks can accelerate the adoption of new technologies, and strategic reserves of commodities can be drawn on. Governments will sometimes smooth over temporary price increases with subsidies or price controls. This can allow central banks to ‘look through’ a short-term increase in consumer prices – to avoid raising interest rates, on the grounds that the inflation caused by the shock will be transient. 

More pernicious are ‘second-round’ effects, when an initial rise in prices leads to further increases elsewhere in the economy. This is when, for example, employees begin to demand wage increases to offset the rising cost of living. If demands are met, they might be clawed back through even higher prices. This can set off a dreaded wage-price spiral, where rising wages push up business costs and prices, prompting workers to seek further pay increases.

The good news, for now, is that central banks are more focused on the first-round effects, which they believe to be temporary. That means the Bank of England has kept the base rate unchanged at recent meetings, while the US Federal Reserve only began its policy-tightening cycle last week. They have some justification for not being too aggressive. Wage growth remains contained as labour markets are subdued. Furthermore, market-derived inflation expectations – investors’ forecasts inferred from bond prices – remain well-anchored. Even so, there’s a bit of a ‘chicken and egg’ problem here. Could inflation expectations be contained because central banks are expected to act more aggressively if required? And what if they don’t? The rising ‘term premium’ for bonds suggests more than a hint of uncertainty on that front. 

Let’s say central banks do, in the end, have to hit the brakes harder. Then we are at risk of a more traditional recessionary cycle developing as demand is deliberately curtailed to bring it back in line with reduced supply. That would tend to dampen corporate earnings expectations, which, of course, have been a key driver of recent portfolio returns. It would be reasonable to expect an equity market reversal. 

Fiscal sustainability – avoiding a sovereign doom loop

Another risk is that investors begin to question government finances. The UK faces high debt and a persistently high annual deficit, but it is not alone: the United States, France, Italy and Japan are in the same leaky boat. 

Spending far exceeds income for several reasons, including the cost of supporting ageing populations and increasing defence budgets. Political pressures also make spending cuts difficult, especially when there’s someone in opposition making (impossible to keep) promises to spend even more. Cyclical issues include potential cost-of-living subsidies, such as help with energy bills. 

Worst-case, investors could fear that governments will struggle to repay their debts, at which point the concerns become almost self-fulfilling. Interest rates rise as investors demand higher bond yields (the return they receive for lending money to a government) to compensate for ownership risk. A bigger chunk of your taxes goes to paying interest rather than being invested in productive infrastructure or even basic services. This could be described as a sovereign doom loop. 

If that sounds worrying, it is. However, as long as a government can tax its citizens and issue debt in its own currency, it can save the situation. The central bank might need to help by buying government bonds, making it easier for the government to finance its debt. But as we have observed from Japan doing this for a couple of decades, the currency tends to devalue against those that are not forced down the same route.

Bond markets turn up the pressure

US and UK 10-year government bond yields have climbed as investors demand greater compensation for inflation and fiscal risk.

How to mitigate portfolio risks?

If it were just about the risk of a typical recession developing, the answer might be to buy more government bonds. They typically rise in value when investors seek a safe haven. But if the recession undermines government finances too severely (and remember we haven’t before entered a recession with such high levels of existing debt), then it’s possible that government bonds themselves become a risky asset. 

That’s one very good reason why we continue to recommend diversification across different industries and countries. Increasingly, we’re exploring diversifying assets that haven’t historically been adopted by mainstream investors. These include tail-risk hedging vehicles, which aim to protect portfolios and deliver positive returns during rare but severe market falls. Macro funds seek opportunities across a wide range of investments, while trend-following funds can benefit from sustained market downturns. Long-short equity funds may also reduce losses by backing stronger companies and profiting from falls in weaker ones. In the event that governments run persistently high deficits and finance them in ways that fuel inflation and weaken their currencies, real assets – such as real estate, infrastructure and commodities – have a role to play. So do precious metals, especially if ‘currency debasement’ – a sustained loss of a currency’s purchasing power – becomes more widespread.