How do you invest if the growth party is over?

The ideas of debtor and creditor as to what constitutes a good time never coincide.

PG Wodehouse

The debtor party has been longer and more boisterous than any sensible, straightlaced economist could or would have predicted. For well over a decade, high growth businesses have boomed on the back of a seemingly endless supply of cheap debt. What’s more, their share prices have skyrocketed because low real rates have left yield-hungry investors with little choice but to sacrifice regular income for the promise of future returns. The net result of which is a US market that is more overvalued than it was in the times preceding the Wall Street Crash of 1929, the 1973 crash, and the Global Financial Crisis. If we’re talking parties, this one has been an absolute riot. But is it over? Last year the arrival of a particularly unwelcome guest – inflation – started to raise that prospect. This year, we’ve seen markets start to react to that reality in earnest.

Why the change in tone?

First of all, what makes this situation a little different to some of these famous market bubbles, is that investors have been – at least to some extent – all too aware of the excess risk that they’ve had to take in order to generate outsized returns. Some have been of the mind that you might as well make hay while the sun shines, while others – if we’re being cynical - are more concerned with relative returns than absolute; they don’t mind how much risk they take on so long as everyone else they’re being compared to is doing the same thing. The reason we’re seeing volatility in markets now, is because there are growing concerns that the regime is changing; that rates are going to go up more steeply than central banks are currently forecasting, and that the growth party might well and truly be coming to an end.

The reason we’re seeing volatility in markets now, is because there are growing concerns that the regime is changing.

False alarm or time to head for the fire exit?

There’s a divide in the market narrative between those who think this is a momentary blip, and those who think that this is the beginning of something much bigger. Funnily enough, probability (and experience) tells you that it’s probably both. We tend to look back and think of major market crashes as individual events, but the reality is rather different. What you actually tend to see is a period of smaller corrections in the preceding months, and even years beforehand. When markets are grappling with a new hypothesis, they tend to test it before they buy into it wholesale. What you’ll see before a full-blown market meltdown, are mini rotations, increasing volatility and the splintering of entrenched market narratives. It’s like Jeremy Grantham’s famous description that the stockmarket behaves like a brontosaurus that’s been bitten on the tail; it takes a long time for the reality of the bite to travel through the dinosaur’s primitive nervous system up to its brain to spark pain.

Some are having more fun than others

In this case, the “bite” is inflation and the higher interest rates that might be needed to tackle it. That’s what’s been behind this shift in market sentiment over the last few weeks, and those investors who’ve paid through the nose for growth are now seeing precipitous falls in the value of their holdings. The Nasdaq – which is the most tech-centric of US indices – has not only fallen below its 200-day moving average, but 40% of its constituent companies have lost half of their value since late November. Growth equities more broadly have also felt the pain; the MSCI World Growth index has lost over 11.5% this year. Meanwhile value equites have not only been largely immune to the selloff, in many cases they’ve seen gains. Financials, which are the largest constituent of most value indices, are up around 5% since the beginning of the year.

Now, as we have said, this doesn’t mean that the value rotation is here to stay. For now, markets are broadly comfortable with liquidity and growth levels but concerned about policy. If that were to change, then we may well see a shift back to longer duration assets. What we can say is that with rates and growth poised to go up, there is a very high probability that value beats growth over the long term. Growth equities face headwinds from policy as well as price, because – and this can’t be stressed enough – they are still extraordinarily expensive. The heat has not yet been taken out of the top end of the equity market, and bond yields are rising but still low, which leaves plenty of room for further falls as and when a new regime takes hold.

Protect now, party later

The good news is that there are ways to protect portfolios against inflation. The better news is that it’s still surprisingly cheap to do so. Despite all the fear and noise, not many investors are buying inflation protection at the moment, and we think that medium term inflation is particularly under-priced. The inflationary forces building up in the system may or may not be transitory, but underneath that there are structural pressures building from higher government spending. That’s a key risk to watch.

Given that bonds and cash aren’t safe havens in an inflationary environment, we think that portfolio protections, hedges and diversifying strategies are crucial. It’s not the most exciting answer, but if you protect your portfolio on the downside then you leave yourself with the option to have a much more interesting time when markets hit a trough. If you can position yourself to be a buyer when everyone else is forced to sell, then you’re in for a very exciting time indeed.

Investment Strategy & Outlook

On the face of it, 2021 was a strong year for equity markets, however there was a wide dispersion under the surface. While US large cap growth did well, small cap growth was barely positive, unprofitable tech names sold off, and abroad in equity markets such as Japan and China, returns were negative for the year. Riding the equity wave in a concentrated way in earnest would have been a highly risky move, as has been made clear by the activity we’ve seen in the first few weeks of 2022. Because prices at the top end of the market had been driven up to such heights by investors’ need for yield-at-any-cost, they fell sharply at the prospect of more hawkish policy and higher bond yields. In our view, avoiding price risk at this end of the market is extremely important for long term investors, as evidenced by these precipitous falls. However, equities in general are not all subject to the same distortions; value equities still look relatively attractive, and broader equity indices still have support from good-enough economic growth and strong corporate earnings.

Our approach is to maintain exposure to upside equity risk, with a tilt towards value strategies, active stock picking and markets outside the US, while adding portfolio protection at the margins.

By working with both actively managed direct equity exposure as well as put and call options, we provide some protection against the risk that markets correct, but also the risk that they do not.

As for inflation, the headlines are stark but the story is nuanced. Yes, the short-term spikes driven by supply chain tightness do look likely to recede over the year, but that’s not to say that no permanent damage has been done. Policy measures to tackle the economic effects of Covid-19 have opened the door to longer-term fiscal expansion, global shutdowns prompted a more rapid transition towards onshoring, and many governments would rather let inflation eat away at their debt burdens than try and raise taxes. The good news for investors is that there are ways to protect portfolios against longer term inflation. The better news is that it’s still surprisingly cheap to do so. Despite all the fear and noise, not many investors are buying inflation protection at the moment, and we think that medium term inflation is particularly under-priced.

The prospect of both higher medium-term inflation and more hawkish policy makes bonds particularly unappealing relative to other asset classes. To reflect this view, we have no exposure to traditional government bonds, except in the case of Chinese bonds, which have a positive real yield, a policy mix which is more supportive of creditors, and which will benefit from the loosening of foreign investment restrictions into China. While there are forces working against Chinese assets in the short term, we think that there is a positive longer-term case for both Chinese equities and bonds. Valuations – a key area of concern for asset prices globally – are relatively more attractive than in advanced economies, China is becoming increasingly dominant on the global stage, and it is home to some of the most advanced technological innovation in the market today.

Lastly, in this environment of heightened risk and market dislocation, we think that active management is key. Over the past few months we have increased our allocation to active managers who can be nimble in times of market stress. We have also increased our positioning in alternative strategies across a broad range of investments, including gold, commodities and active 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.