As Wile E Coyote is navigating the New Mexico desert he will occasionally hit a canyon. Momentum carries him far into the air, his legs frantically pedalling, but he eventually succumbs to the inevitable, crashing to the ground in an inelegant heap. Taking the mood of a range of investment managers, this is exactly what may be happening today in financial markets.
They believe that the volatility seen since the start of the year is only the start of a prolonged period of instability. At the moment, markets are in the pedalling moment, before they accept that higher interest rates, weaker corporate earnings and slumping economic growth will inevitably drag them to earth with a splat.
Every investor knows that the golden rule of long-term returns is to stay invested through tough times. While no-one would suggest exiting the market at these levels, against this backdrop, there may be an argument for retaining ‘optionality’: in other words, keeping some cash in reserve just in case there are better opportunities to buy in future.
Earnings downgrades will make the difference
Many commentators believe stock markets are not yet discounting bad news. Anwiti Bahuguna, head of multi-asset strategy at Columbia Threadneedle, says: “So far this year [market weakness] has been an entirely rates-driven story. As rates have priced higher, equity multiples have compressed. Earnings have remained pretty elevated for this year, even with the damage we anticipate in the next six to 12 months. This year, it is possible we might squeeze in 6-7% earnings growth, but expectations for forward earnings are coming down for 2023 and may come down even more sharply from here.”
She also believes higher rates are not yet fully priced into stock markets. “There is some more damage to come in the bond market.” However, it is earnings downgrades that will really make the difference: “Even though companies have not come in and downgraded to a negative absolute number, the trend is that revisions are negative.” At the moment valuations are in a neutral range, she says, leaving plenty of scope for market multiples to fall further. She concludes that there is the potential for more pain in the equity market.
In this, her views chime with those of the BlackRock Investment Institute, which gave this gloomy assessment in its most recent update: “We think central banks are set to overtighten policy in the near term causing economic damage – and flare-ups of financial stability risk – that equity markets may not be fully appreciating yet. We stay underweight developed market equities in our tactical views.”
It added: “We think equities are just starting to price in a worsening macro outlook. We see more room for equities to fall as prices are still not fully reflecting the combination of recessionary risks and higher interest rates. Consensus earnings expectations for this year and next still appear too optimistic to us given the growth backdrop.”
Cash = less loss
Let’s not forget that bonds don’t look fantastic either. The diversification benefits of holding bonds alongside equities are largely non-existent today. Some economists have suggested that the diversification benefits only exist at times when the market is focused on growth. When inflation is the preoccupation of investors, both stocks and bonds do badly.
Rob Burdett, head of multi-manager solutions at Columbia Threadneedle, says in this environment there is a real question over where investors can find safety: “Gold isn’t working yet. Inflation-linking hasn’t worked – at least in the UK, where inflation-linked bonds are down almost 40% for the year to date. Bond managers in credit aren’t rushing in just yet. Equities haven’t dropped that much. It’s why cash can be a good choice, at least for optionality.”
He says the market has an enormous amount to work through this year. There is quantitative tightening, plus ongoing problems with supply chains. The implementation of net zero could be inflationary. He points to the ‘rule of 20’. This is a measure of stock market valuation, which states that the stock market is only fairly valued when the sum of the average price-earnings ratio and the rate of inflation is equal to 20. On this measure, the US stock market may have another 20-25% fall ahead of it. Bonds have weakened, but there could still be considerable pain ahead.
Are there any exceptions? Bahuguna says Japan is the only country not experiencing corporate downgrades. There will also be certain sectors that will continue to thrive – healthcare, perhaps, or energy. Equally, investors may want to look at relative value plays rather than directional plays. For example, most investors have long lost faith with the targeted absolute return sector, but the average fund is down just 1.1% over the past 12 months. Polar Capital Global Absolute Return, Gam Star Global Rates and Fulcrum Diversified Core have all had a ‘good’ bear market.
However, navigating this market would require exceptional asset allocation skills and considerable predictive powers. With that in mind, cash has much to recommend it in this environment. Fund manager’s cash levels peaked in July at 6.1%, its highest in 20 years. It fell back slightly in August to 5.7%, but remained well above the long-term average of 4.8%. Investors are still losing money in real terms in cash, but they may lose less and it may enable them to buy as opportunities bubble up amid the market turmoil.
Even with a contrarian slant it is difficult to make a compelling case for the stock market today. Cash is always controversial, but a strategic weighting in cash could help avoid the Wile E Coyote slam at the bottom of the canyon.
