The case for embracing difficulty

The way I see it, if you want the rainbow you gotta put up with the rain.

Dolly Parton

Nothing in this world is worth having or worth doing unless it means effort, pain, difficulty.

Theodore Roosevelt

Dolly Parton and Teddy Roosevelt may optically have little in common, but they certainly shared a common understanding of a fundamental truth; that a certain amount of difficulty creates things that are worth having. But it doesn’t necessarily follow that the more difficult something is, the better the end result; in a great many pursuits there is a balance to be struck. One of the lesser-guarded secrets of making truly great wines for example, is that you need to make the vines work harder than they want to, but not so hard that they can’t produce grapes. If conditions are too easy, they’ll soak up what’s available on the surface and you’ll end up with uninteresting wines. But make conditions just harsh enough, and you’ll force the vines to reach for deeper, more interesting soils. The end result will be something altogether more complex, and longer lasting.

If it’s not great wine that you’re trying to create, but economic growth, then the same logic applies – and it is central bankers who keep the balance. Keep conditions easy with low rates and high liquidity, and businesses might thrive on easy access to cheap money, but you sacrifice longer term productivity as weaker companies are able to limp on for longer. You also raise the risk of economic overheating, leading to every long term saver’s worst nightmare; inflation. Conversely, by keeping rates high and turning off the liquidity taps, you make conditions too difficult for good business to thrive, and you stifle economic growth. This is a difficult balancing act at the best of times, but in today’s environment it is an extraordinary challenge, and it is one that every investor on the planet is watching out for.

Walking the growth/inflation tightrope

Right now, the global economic recovery looks to be – patchily – underway. There are bumps in the road thanks to the mixed success of vaccine rollouts, but the global economy is in firmly expansive territory. So much so in fact, that fears are starting to build that this growth could fuel inflation, and that’s why US Treasury yields have spiked 240% since their lows of 2020. Now admittedly this is from a low base, but it is a startling move nonetheless, and it goes to show how sensitive markets are to this growth/inflation tightrope. It’s also not hard to see why; if you’re a bond investor today inflation doesn’t only erode the value of the fixed interest you receive but also the capital value at maturity. That’s why when there are signs of economic overheating, it is bond markets that sound the alarm; they are the first to feel the heat.

When there are signs of economic overheating, it is bond markets that sound the alarm.

Of course, these fears of inflation may well be misplaced, or premature. There was a great deal of concern that the monetary stimulus to tackle the 2008 Financial Crisis would lead to inflation, and it simply never materialised. Or perhaps more accurately; it created inflation in asset prices, asset prices, but not in the value of goods and services. Why might this time be different? For one thing bank balance sheets are in better shape; they have nearly twice as much capital for every dollar they spend than they did in 2008. But perhaps more importantly, we are no longer living in an age of austerity. Central banks were doling out cash post 2008 while governments were tightening their purse strings. Today we’re seeing extraordinary amounts of stimulus from both quarters, and central banks have explicitly stated that they’re now willing to let inflation overshoot.

Why difficulty is a (good) investor’s best friend

We appear to be at a moment of genuine regime change. For the last 20 or 30 years, investors have been able to comfortably rely on bonds to act as both ballast and diversifier in portfolios. While in the decade since the 2008 Financial Crisis, easy conditions have also been boosting broad equity indices. Today, equities are expensive, bonds even more so, and the negative correlation between the two has broken down. What that means in practice is that we cannot expect the asset allocation strategies that worked in recent history to continue to work in the future. To put this back in vintner’s terms; we have become used to an environment in which the surface soils are rich enough to swell the pickings, but from here in on, investors are going to have to reach much deeper.

Today, equities are expensive, bonds even more so, and the negative correlation between the two has broken down.

The good news is that while a straightforward mix of equities and bonds is very unlikely to be enough to power solid risk adjusted returns for investors, there are more interesting strategies out there today. Alternatives are likely to play an ever more important role in asset allocation, providing diversification and differentiated drivers of return. What’s more, this is an environment which is likely to let real investment talent shine. There are outstanding managers out there, whose strict valuation disciplines have priced them out of the equity market boom of the last few years. Now, as yields rise these managers have seen a turnaround in their fortunes, and those with a value bias have been posting strong returns since the end of 2020.

All in all, we think there is little doubt that conditions for both markets and investors are going to have to become more challenging in time, but to paraphrase Teddy Roosevelt, our job wouldn’t be worth doing if it didn’t involve a little difficulty.

Investment Strategy & Outlook

On a broad basis, we think that this is a good environment for active investors. While we do have passive exposure to areas where markets are more efficient and valuations are cheaper such as the UK, we currently have a greater weighting towards active managers who can capture the opportunities created by market price dislocation and regime change.

Within equities, we have a mix of both active and systematic strategies, and we are positioned to take advantage of the parts of the market which are most attractively priced. We think that value equities are well positioned to benefit from the economic recovery and rising bond yields. We believe equities in the US are amongst the most expensively priced, and tilt our exposure to developed markets outside the US, Emerging and Frontier markets. This overall value tilt is balanced with selective exposure to quality stocks, areas that benefit from Chinese growth, and an options overlay strategy that enables us to tap into broader equity market momentum without taking on the downside risk of buying into expensive US equities.

Thanks to both the low starting yields, and the risk of inflation, bonds do not offer the same diversification and risk management characteristics that investors have become so used to over the past 20 to 30 years. While we do have an allocation to fixed income to protect against deflationary forces, we are highly selective in our approach. We actively manage – and are currently underweight - duration, and have greater exposure to active management, securitised debt and Chinese bonds

Most importantly, we are not limited to using fixed income exposure as a diversifier to broader equity risk. Instead, we are making use of a broad range of alternatives and liquid real assets. From gold, commodities and inflation linked bonds, to actively managed alternatives strategies with idiosyncratic drivers of returns, such as long/short strategies, and macro hedge funds.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our terms and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.