CIO Lens Q3 2022: are we nearly there yet?

To anyone who ever travels with children, the incessant question “are we nearly there yet?” will be a familiar refrain that punctuates any long-distance car journey. It’s certainly a favourite of my seven-year old daughter.

Now, I find myself sounding like her. That’s as I look at the dramatic declines across fixed income and equity markets and think about whether markets are now cheap enough for us to increase our tolerance for investment risk.

So - are we nearly there yet? The answer right now is “not quite yet”.

The game has changed

Rising interest rates represent a major regime change after years of quantitative easing. This policy, which saw central banks like the US Federal Reserve buy trillions of dollars worth of bonds, resulted in interest rates being pinned at zero with the intention of encouraging borrowing and supporting markets. It meant that investors searching for yield and returns were forced up the risk curve – that is, into riskier assets.

I've previously described this as being like a game of "whack-a-mole", the arcade game in which players must be on the lookout for moles popping out of holes to quickly whack on the head with a mallet. When you hit one, it disappears, and another appears elsewhere.

In the market sense the parallel is that any hint of a yield that has appeared in recent years been quickly met by a wall of money from investors looking to escape negative real rates. When one becomes overdone, everyone starts looking for the next. Against this backdrop, volatility was suppressed, and any traditional concept of valuation went out of the window.  

As central banks now rush to raise rates to cope with high levels of inflation, the game has changed. We are moving from whack-a-mole to a game of chess. Investors face a more strategic, adversarial challenge, in which the opponents are the central banks.

Price check

For now, central bankers’ priority is not to support markets, but to quell inflation on "Main Street". This means we need to find a new equilibrium for valuations against a backdrop where the disinflationary maps of the past might not work in the future.

The good news is that valuations have improved on many metrics. We now see value in the level of bond yields after a torrid period for bond markets in which yields have surged (prices fall as yields rise).  

Certainly, bonds are less vulnerable to the risk of recession than equities, where we believe that uncertainty around earnings is still not adequately reflected in valuations.

Our quantitative models that assess where we are in the economic cycle are pointing to a shift into the "slowdown" phase, when earnings expectations are disappointed. This is typically the most challenging phase of the cycle for equities and so we remain underweight. 

Recognising that growth risks are increasing, we have also closed our overweight position in commodities due to concerns about demand destruction in the energy sector. 

Within equities, we continue to have a bias towards value as a style.

Lessons from previous bear markets

So, what have we learnt from our experience of previous bear markets?

Firstly, as valuations adjust to a new equilibrium, we will see strong bear market rallies, in this case particularly if inflation shows signs of peaking. Investors need to ensure their decision-making process is dynamic enough to cope with this or diversify your risk to avoid being whipsawed.

Secondly, the best valuation opportunities tend to emerge in recessions. So, as the growth picture darkens in the next few months, don’t get too bearish!

And finally, in volatile markets, you are more likely to make expensive mistakes. Investors need to remain focused on their strategic plan, nurture the resilience of their team and avoid over-steering.