Expert: Ian Rees, Investment Director, Ruffer Facilitator: Helen Clark, Owner and Director, Mint Blue Consulting Ltd
Headlines:
- Inflation has risen rapidly from multi-decade lows - US inflation hit 9.1% in June 2022, a 40-year high, while UK inflation reached 10.1% in July 2022. This contrasts with inflation averaging around 2% for the past 30 years, which was very low historically.
- Central banks have sharply tightened policy - To combat high inflation, central banks like the US Fed have quickly raised interest rates from near zero to around 4%. This risks damaging an economy with high debt levels.
- Early signs emerge of slowing economic activity - Indicators like declining US job openings and tighter bank lending suggest monetary tightening is starting to impact growth.
- Equity valuations look stretched - Despite higher yields, US stock valuations remain elevated based on forward P/E ratios versus historical averages.
- Corporate credit offers very little risk premium - Corporate bond spreads have tightened significantly and offer minimal extra yield over safe Treasuries.
- Asset correlations are changing with inflation - Bonds and stocks have tended to move together during periods of high inflation, undermining traditional portfolio approaches.
- Portfolio risk levels may be too high - With higher yields available, portfolios likely require less equity and other risky assets to hit return targets.
- Younger investors have a different perspective - Despite openness to risk-taking, younger generations still seek advice and reassurance during volatile times.
- Active management is crucial in this regime - Correlations between assets will shift frequently, requiring active changes to portfolio positioning and risk management.
Discussion:
The session discussed a range of topics related to the economy, markets, and investing as well as high inflation, rising interest rates, recession risks, market volatility, changing correlations between assets, portfolio construction challenges and generational perspectives on investing.
Inflation has risen significantly and may remain high and volatile going forward. This contrasts with the very low and stable inflation of the past few decades.
To combat inflation, central banks have aggressively raised interest rates. This has major impacts on an economy with high debt levels. There are signs monetary tightening is starting to bite, like declining job openings and tighter lending standards.
Equity markets have remained resilient so far but risk premiums are very low. Earnings face risks from higher rates and slower growth. Overvalued areas like tech could be vulnerable.
Corporate bonds offer very little extra yield over risk-free Treasuries. Risk premiums across markets look too low.
Asset correlations are changing as inflation rises. Bonds and stocks may start moving together, undermining traditional 60/40 portfolios.
Portfolio risk levels should be reduced in this regime of higher yields. Many allocations still seem too aggressive.
Younger generations have a different perspective, being more used to risk-taking and losses. But they still want advice and reassurance during volatile times.
Active management will be crucial to navigate changing correlations and macroeconomic risks. Key numerical data includes:
US CPI reached 9.1% in June, a 40-year high. UK CPI hit 10.1% in July, a 40-year high.
US Federal funds rate rose from near-zero to 3.75-4% range within six months. Meanwhile US job openings have fallen around 10% from the peak, an early sign of slowing activity.
S&P 500 forward P/E ratio remains around 17-18x, well above 10-year average of 15-16x. US’ 10-year Treasury yield spiked from 1.5% to nearly 4% but has since eased to around 3.5%.
To earn a 7% portfolio return required 85% equities in 2021 but only 35% equities in 1991, showing impact of lower bond yields.
Energy's weighting in the S&P 500 fell from over 10% historically to just 2-3% recently, suggesting under-ownership.
In summary, the economic and market environment has undergone major changes compared to the pre-pandemic decade. Investors face heightened macro risks and uncertainty going forward. Portfolios are likely to require significant adjustments to reduce risk, diversify into alternative assets, and focus on capital preservation.
Key takeaways:
- Review asset allocation and risk exposures in light of regime change - reduce equity and corporate bond exposure, diversify into alternatives
- Focus on capital preservation and asymmetry - portfolios should benefit from inflation/volatility but with minimised downside
- Emphasise active risk management as correlations shift - don't rely on passive set-and-forget approach
- Help clients understand need for long-term perspective during volatility - remind them of financial plan progress
- Keep clients updated on portfolio positioning as macro environment evolves - clearly explain rationale behind changes
- Look for opportunities in undervalued assets like commodities and Japanese yen that could benefit from the macro backdrop
- Monitor leading indicators for changes in economic trends to allow early adjustment if slowdown deepens or inflation pressures ease
- Review client portfolios to ensure suitability across generations - different perspectives require tailored advice
- Consider providing simple reassurance rather than over-explaining short-term market moves
- Leverage behavioural finance insights to discourage detrimental short-term reactions - help clients stick to plans
