Consider a lower risk profile in order to protect against further downside risk.
- Tuesday, May 24, 2022
As far as the US S&P 500 index is concerned, we are nearly in bear market territory with falls of almost 20% this year while the FTSE100 is down 7%. Investors have endured the pain of a pro-longed decline in asset values.
Everything that has happened is ultimately a response to ultra-high inflation standing a 9% in the UK and set to rise, but 8.3% in the US and may have started to taper. To counter these price conditions, central banks like the US Federal Reserve and the Bank of England are talking tough on rate rises throughout the summer to get on top of inflation.
This inflation episode is driven by supply disruptions and Russia’s war on Ukraine leading to demand exceeding supply. Meanwhile, the labour market is very tight and consumers are willing to accept higher prices for non-essential goods while they still have excess savings from the pandemic. This has created the real risk of inflation once again turning structural, which explains the fervour from central bankers.
We have had a decade plus period of government money being pumped into the economy pushing up prices. Now the central banks are starting to drain the lake in order to control prices. The war in Ukraine has hit commodity prices and the Covid lockdowns in China has hit supply chains. Central banks will not start easing on rate rises until inflation is seen to be under control. This is most likely to first occur in the US, as their inflation may have peaked.
Typical bear markets fall by 30% and therefore the S&P 500 has another 10% to match that average. All markets will be dragged down in that scenario. The Nasdaq is down 28% this year so is close already.
In this environment, we could equally witness a relief rally in the summer as US inflation rates and bond yields start to ease offering some stability to move forward from or markets could become more pessimistic and fall further. It is quite possible that the majority of market repricing has occurred but equally we could see more falls. Markets are nervous and no one is certain.
According to the most recent Bloomberg surveys, most of the leading economists in the US do not think a recession is imminent, and further evidence suggests inflation readings and high yield credit spreads have stabilised. The US 10-year treasury yields have fallen back to 2.8% from 3.12% two weeks ago. JP Morgan’s President Jamie Dimon has recently given an upbeat message about the US economy avoiding recession which led to a rise in US stocks. The press however is more doom laden and full of recession talk.
The recession talk has ramped up because central bankers have done such a good job in convincing us they are unafraid to choose inflation-fighting over growth support. US Fed Chair Jay Powell confirmed it will keep raising rates until inflation is back under control. But this tough talk is not just confined to the Fed. Here in the UK, the Bank of England Governor Andrew Bailey has been describing “apocalyptic” conditions, while Chief Economist Huw Pill’s belief that inflation won’t be brought under control before the end of the year tells us of similar determination.
The central bankers are threatening that there is worse to come unless we cut back spending and/or refrain from asking for pay rises. This may be considered a more effective short-term strategy to fight inflation by curbing consumer demand than the blunt and time lagging instrument of a raft of rate hikes. The Bank of England Governor Andrew Bailey suggested that the cost-of-living slowdown could do the banks job for them and that UK interest rates may not therefore have to rise as much as expected.
This is where economists and institutional investors may take some positives from. We could witness a reduced prospect of persistent rate rises and thereby the risk of recession. The headline inflation figures may have been a shock for the general public, but were widely expected by markets, and therefore priced in. The fact that inflation numbers did not overshoot expectations, and were driven by quite explicit components was enough to lower recession expectations.
While no one can know where Russia’s war will lead, we note that energy capacity and food supplies from other global regions are being redirected. For example, this week led to the UK having more liquified natural gas coming in than can be stored, used or passed on to the continent. High prices create powerful incentives in a market economy, and this is no exception. Another is the incentive for the Chinese leadership to regain the economic initiative, after their ‘Zero-Covid’ strategy blunders left China seriously behind its growth targets. President Xi’s government has just announced a significant stimulus programme aimed at creating jobs by increasing manufacturing capacity. In the past this increase in supply has had a deflationary impact on global markets in finished goods.
It seems that the aggressive messaging from central bankers has been successful in driving down demand while global supply issues can be expected to be resolved. The European gas price issue may not be solvable before winter, but recent redirection efforts indicate that the longer-term fallout may be less than feared, while also stoking economic activity to prove to Vladimir Putin that Russia’s energy exports are not indispensable.
Markets are finely balanced and therefore our view is to consider a more cautious position with asset allocation and that investors should consider a lower risk profile over the months ahead in order to protect against further potential downside risk. There is obviously a risk that markets may rebound in the near term and this rebound would be reduced in a more cautious portfolio. However, we feel that the likelihood of a near term rebound is not great at this present time.
At this coming portfolio rebalance, we have the following options for existing Estate Capital portfolio investors.
1 Stay in your established risk profile portfolio.
2 Move to a lower risk portfolio i.e. Move from Risk 6 to Risk 4.
3 Move to our Cautious Risk 3 portfolio.
On top of these options, we can now offer a mirror copy of our Estate Capital Portfolio but managed on a discretionary basis by our sister company Crossing Point Investment Management. These portfolios have an additional risk control overlay that trades funds out of a portfolio when markets are weak and holds the funds when markets are stronger.
4 Move to the Crossing Point Fusion Portfolio based upon your existing risk profile.
We explained this new range of discretionary managed portfolio in our newsletter and blog post of 21st April.
Options 2 and 3 would be a temporary move while a move to a Crossing Point portfolio would be longer term. Please inform us of your choices either by email or writing on your rebalance request form. If you require further information please call.
Expect your rebalance requests to be with you by first week of June. Please respond as soon as possible.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.