Reflections on a challenging half year for markets

It has been a difficult first half year in markets. An unwelcome characteristic is that both equities and bonds have lost value at the same time, rather than providing diversification – a feature of inflation shocks is that they tend to lead to correlation in these asset classes.

At a simplistic level, we’ve seen two phases to the market’s gyrations so far this year. In the first three or four months, the focus was on inflationary concerns, which negatively impacted bonds as well as causing high-growth stocks, which have outperformed significantly in recent years, to give back some of those gains. At the same time, previous laggards such as more cyclical, ‘value’ stocks fared relatively well in the rising interest-rate environment. Over the last couple of months, the focus has shifted. Growing concerns over an economic slowdown and potential for a global recession has caused a broader sell-off in equities while bonds have shown notable stability.

It is always important to remember that markets are forward-looking, pricing in expectations and, in the short term, are very sensitive to sentiment and so-called ‘animal spirits’. We believe successful investing requires discipline and how you react during the tough times is often more important than how you react during the good times.

At its core, investing is all about managing risk – embracing those risks that the market generally rewards over the long term while avoiding those risks that does not (often the more speculative fads).

There are two important sub-elements to this: the first is to diversify across different asset classes, styles, geographies and sectors. This means a portfolio is not overly exposed to any one specific risk or binary event. The Nobel Prize winning economist Harry Markowitz is reported to have said “Diversification is the only free lunch in investing” and the numbers back him up.

The second is to take a long-term view when investing and to help ride out short-term market volatility. This is crucial, as it gives you time to recover from unforeseeable market downturns. However, it is important to resist the urge to sell out when markets are down as that could lead to turning what may be a temporary ‘paper’ loss into a permanent one.

Markets are inherently cyclical and volatile. There is always something new around the corner to worry about, but markets adapt. Taking a long-term view is vital to successfully navigating changeable and volatile markets.  It helps you keep focus on the destination (not the journey) and protects you from making mistakes. With patience, we expect you to be well rewarded by potential gains in the future.

We make projections both for the long-term range of return outcomes and also some of the volatility and drawdowns expected along the way, and while we can’t reliably forecast exactly what will cause these downturns, we can model what might reasonably be expected. This helps us build portfolios that meet your objectives and attitude to risk. Focusing on and being cognisant of your risk profile is so important as it helps to deliver on your long-term goals in a way that you are comfortable with.

As mentioned, markets are forward looking and that means they are already pricing in a lot of bad news. It is clear that central banks are determined to bring inflation under control, even at the cost of economic growth, and that is what markets are acutely focused on now. There may, of course, be further volatility ahead but I’m reminded of a great quote from the noted investor John ‘Jack’ Bogle:

Indeed, looking at the recent US inflation numbers (see the chart below), which were once again ahead of expectations, it is easy to fret. However, while the headline numbers continue to push higher, once you strip out food and energy, there are signs that core inflation may have peaked. Sadly, this won’t help with the cost-of-living crisis because fuel and food are important components of that, but central banks are likely to focus more on core inflation, which they are able to influence, albeit with a significant lag. We should also remember that if there is an economic downturn, this would likely be highly disinflationary. In addition, governments and central banks have the tools to kick-start growth on the other side through fiscal and monetary stimulus, which we believe markets will, at some point, start to price in as they look to the future.

Chart 1: US core inflation is falling

In recent months sentiment rather than fundamentals has driven markets significantly. We are now in the key reporting season for many global companies and this will give us important insights into company outlooks and earnings that underpin equity returns. We will be watching these fundamentals carefully over the next few weeks on your behalf.

There is no escaping the fact that the first half of the year has been tough, with inflation concerns giving way to recession concerns, weighing on bonds and causing a broad sell-off in stock markets. However, such indiscriminate selling creates opportunities for patient, long-term investors. It is vital to remain disciplined during market turbulence and focus on the long-term potential made possible by embracing selected risks in line with your risk tolerance and suitable time frames.