CIO Lens Q3 2023: Lessons from the school of hard markets

As we reach the mid-point in the year, it’s important to reflect on our investment performance and discover what we can learn from both our successes and our mistakes.

As a parent I am always trying to instil good habits into my children, especially at this time of year when my son is sitting exams. Although he barely listens to a word I say, I persevere in the hope that he’ll remember some of what I say one day, and it will help him in the future.

Hopefully he knows that both personally and professionally I believe in having a learning mindset – always looking to learn from others and from my own mistakes.

From my side, the market keeps on schooling me on the importance of staying humble and focused on our investment process. The halfway point of the year is a particularly good time to reflect on our investment performance; what’s gone wrong and what’s gone right, and what I can learn.

And not everything has gone to plan recently.

Earlier this year, the multi-asset team positioned for a slowdown in economic activity. We did this through an overweight position in bonds and an underweight position in equities.

In the last month we’ve seen this view challenged on multiple fronts. Labour market conditions remained tight. All the major central banks surprised markets with higher interest rates or hawkish comments. In the US, continued strength in services outweighed the ongoing signs of weakness in the manufacturing and goods sector. Meanwhile, the potential tail risk represented by the US debt ceiling wrangling was averted.

Read the full CIO Lens here

As a result, equity markets – which had been trading in a fairly narrow range in recent months – rose and bond markets fully reversed any expectation of the Federal Reserve (Fed) pivoting on interest rates, seeing bond yields climb.

Over the last 12 months we have repeatedly said that signs of softening in the labour market would be required for the Fed to back off from raising rates. Although other measures of inflation such as energy and food have clearly turned, wage growth is still too high for comfort. This means monetary conditions are likely to remain restrictive and we expect economies to slow down later this year as credit conditions gradually tighten.

At the same time, we are still concerned about equity valuations at a time where you can still get a decent yield just by sitting in cash. The challenge is that timing is important. With the labour markets still resilient, it is difficult to see an imminent move into recession this summer and there is less short-term danger to corporate earnings. Consequently, we have decided to reduce our underweight position in equities to manage our risk and move closer to neutral.

In the case of bonds, the main challenge is that the inverted yield curve (with longer-term bonds yielding less than their short-term counterparts) makes an overweight position in US bonds expensive to hold. Consequently, we have rotated our overweight position in government bonds into a long position in European investment grade debt as this offers a high-quality spread that buys us time as we wait for the slowdown. We remain overweight in local currency denominated emerging market debt as many of these markets offer improving inflation dynamics and relatively attractive yields. In short, we favour strategies that give us a positive carry as we await fresh opportunities.

So, as I look back over the year so far, it’s clear some of our positioning hasn’t worked and we have struggled to catch a trend. We are now reducing or closing some of our defensive positions, reflecting the reality that the expected slowdown has failed to materialise quickly enough.

At times like these, it is as important as ever to be disciplined about how you manage your risk.

As I've mentioned before, our investment processes often exist to "cope with failure". With a hit rate of 60% seen as being very strong, the reality is that, even if we are good at our jobs, we are making "wrong" decisions 40% of the time.

It is important to recognise mistakes early and guard against "rationale drift"; in other words, making sure you don’t lose sight of the original reason for making an investment.

As an investor, resilience is a key trait and every time you make a wrong call, you chip away at it. I sometimes describe it as having to manage a "failure budget" over your career.

By cutting your losses or having other means of managing your psychology through difficult markets, you can preserve your emotional energy and your ability to take risk for when opportunities avail themselves. This allows you to use up your failure budget slowly and live to fight another day in markets.

In this quarter’s CIO Lens:

• Nils Rode, CIO Private Assets, provides detailed thoughts on the risk and opportunities that are emerging in each private asset class, as a broader slowdown takes hold.
• Andrew Howard, Global Head of Sustainable Investment, discusses why the silent majority are more focused on returns than ideology when it comes to sustainable investing.
• Our multi-asset team takes you through their asset allocation views across all the major asset classes, including why they’ve upgraded equities and credit.
• Chief Economist Keith Wade and his team discuss their current economic risk scenarios.

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