The world is changing, so how do you invest?

It had long since come to my attention that people of accomplishment rarely sat back and let things happen to them. They went out and happened to things.

Leonardo da Vinci

Tomorrow belongs to those who can hear it coming.

David Bowie

The cost of living is rising rapidly, the value of cash is dropping by levels not seen for thirty years and energy bills are eye-watering. We’ve all felt it. Some have even resorted to putting warning stickers on their thermostats; “do not turn me up unless you have a) put on a jumper b) done ten star jumps and c) looked at last month’s heating bill”. For many, the pain has also been felt in their investment portfolios, particularly if they had a lot of bond and growth equity exposure coming in 2022. All in all, this is an easy environment in which to lose money. So how you do you avoid it in your investment portfolio? What does the sticker that stops you from making bad decisions with your capital say? We would argue that what is needed in today’s environment is a willingness to accept that the world is changing, and that your strategy might need to as well.

The beginning of the end of the longest bull market in living memory

We’ve been talking about economic and market regime change for a while, and now it’s here. The trends that we’ve seen so far in 2022 are the reversal of what we’ve seen in the decade or so since the Great Financial Crisis. In a nutshell, the most efficient way to compound your capital in that period, was simply to ride the equity bull market by buying passive equity and to hedge your risk with bonds. With inflation low, economic growth moderate, and liquidity high, these assets were perfectly primed to flourish. So it’s no surprise that with inflation high, growth low, and liquidity about to be reduced as central banks turn off the taps, growth equities now look extremely precarious, and bonds even more so. To add insult to injury, bonds and equities are suffering simultaneously, which means that the trusty 60/40 portfolio no longer provides effective risk management. While passive exposure, which has been so efficient over the past decade, now looks risky thanks to the distortions in market pricing.

The trusty 60/40 portfolio no longer provides effective risk management.

A fundamental shift in investor psychology

The first thing to note, is that while the economic and market regime is undoubtedly changing, it has not done so in one fell swoop, nor would we expect it to. What we’re seeing now is what you always see at the beginning of a major shift; markets testing a hypothesis before buying into it wholesale. We’ve seen growth equities sell off heavily this year, but it takes a lot more than a couple of quarters to profoundly shift investor psychology, especially given that many of today’s investors have never experienced a true bear market. What we have seen this year, and will expect to see for some time now, is a cycle of corrections and recoveries.

Despite the longer term headwinds for long-duration assets, investors are still conditioned to “buy the dip” when it comes to growth equities. They have been phenomenally successful over the past decade, with a great deal of investor talent drawn towards specialising in those strategies, so it will take time for that bias to unwind. Bonds are likely to see similar spikes and troughs, but for very different reasons. Few investors today would argue that bonds look attractive over the long term, but Russia’s invasion of the Ukraine has significantly increased the risk of a recession within the next few years, and as perceptions around that likelihood shift, so too will bond yields.

Balancing the long and the short term

What does all this mean for investors? Ultimately it means that you need to be diversified in a more sophisticated way than you have had to be over the past decade. Over the long-term, we think that inflation, low growth and the move towards a multi-polar world presents a fairly clear picture for portfolio positioning; in that environment you want inflation protection, geographical diversification (with less of a US bias), and value equity exposure, amongst other things. But in the short term, those assets alone would give you quite a volatile ride, so balancing them with a small amount of exposure to carefully selected longer duration assets is important.

As we have said, while the shift that is underway in economics and markets is profound, investor psychology takes a long time to readjust. What we’re seeing today is a clear shift in market rhetoric, but that shift is not yet fully reflected in investor positioning. Our view, is that it’s important to be on the right side of this dynamic before it happens, helping our clients enjoy the benefits of the first mover advantage. No-one wants to sit back and let a changing tide wash away their capital, especially when hindsight will tell them that there were ways that it could have been avoided.

No-one wants to sit back and let a changing tide wash away their capital.

Seeking unloved asset classes

So what can you invest in today that might stand a good chance of compounding capital in the future? A good rule of thumb is always to seek out areas where capital is scarce, but likely to increase over time. Hedge funds have been unloved for many years now; they were the problem child of the financial crisis, but if you look back further, many were phenomenally successful when the tech bubble burst, and there are clear parallels between that period, and the environment today.

Similarly, low interest rates have been awful for futures trading funds, but with rates rising, they look relatively attractive, and can act as a useful source of diversification. We’ve seen a slight pickup in investor interest in these strategies, but they’re still not seeing the flows that you might expect to see in this environment. All in all, these might be troubling times, but for investors who are willing to be nimble and not be psychologically anchored to the assets of the past, there are plenty of opportunities to compound capital.

Investment Strategy & Outlook

On the face of it, 2021 was a strong year for markets, but riding the equity wave in earnest would have been a highly risky move; as has been made clear by the activity we’ve seen in the first months of 2022. Because prices at the top end of the market had been driven up to such heights by investor 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. Even more risky however, would have been to use bonds as your main diversifier, as equities and bonds have been selling off simultaneously throughout the market volatility that we’ve witnessed so far this year.

Russia’s invasion of Ukraine has complicated the macroeconomic and market picture. It has not added new risks – the threat of inflation or low growth was clearly already there – but it has affected the balance between them. In the simplest terms, starkly higher oil and gas prices increase the risk of a recession, as well as further stoking inflation, which increases the overall risk of the dreaded stagflation scenario, where inflation rises even though growth slows. Even if the current inflationary spikes - which are largely driven by energy prices and supply tightness - begin to recede, we are still likely to see inflationary pressures in the medium and longer term. 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. Given these combined pressures, we think that inflation protection is extremely important in portfolio construction.

Our broader positioning for clients - cautious, well diversified and with minimal direct exposure to growth equity – has been beneficial in this environment of heightened risk. Given the medium and longer term risks of inflation, we think bonds are 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, and we have limited exposure to credit. In order to maintain a high degree of portfolio diversification we are making use of commodities, gold and active strategies with idiosyncratic return drivers, such as long-short strategies and macro hedge funds.

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, and opportunistic when the time is right.

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.