Haven’t we seen this before?

Think back to the spring of 2023. Central banks were walking the tightrope of beating inflation whilst avoiding recession using the fairly blunt instrument of interest rate policy, along with some other monetary policy measures. Then we had the “banking crisis”; markets were all over the place and interest rate expectations dramatically changed as it was thought that central banks had another global financial crisis to deal with. It slowly all went away and unwound.

I’m not saying that this will happen again with this set of circumstances as they are different, but markets do over react.

Now, let’s think all the way back to the week beginning 29 July 2024. We went into the week looking forward to policy announcements from the Fed, the Bank of England and the Bank of Japan (BoJ). We always have lots of economic data, but US employment numbers attract a lot of attention as they are a good barometer of US economic health, and they were due as well.

Putting Japan to one side for now, the overall back drop was that inflation was slowing, but remained a concern, economic growth was slowing nicely and as a result interest rates were heading lower, BUT, we were worried that if rates didn’t fall fast enough, growth would slow too much. All pretty normal stuff.

All at the same time

I have written before about some complacency in markets. The range of sentiment and positioning indicators we looked at were suggesting that markets were benign and complacent over the many risks around – Magnificent 7 valuations, inflationary risks, growth risks, geo-political risks – and that a negative surprise could be painful.

Then we had this all happen in a short space of time.

• The share prices of the Magnificent 7 were weakening, partly through the fact they looked expensive on some measures and partly through disappointing corporate results announcements. The rotation away from them into other parts of the equity market looked to be starting, with small caps benefiting.
• The Fed didn’t cut rates on 31 July, as expected. However, many thought they should. They pointed to a robust economy and inflation still being a bit sticky and guided us to a cut in September.
• The BoJ lifted their short term policy rate to 0.25% and guided us to further tightening measures after nearly 30 years of very low rates and yield curve control.
• US non-farm payrolls showed that the economy added ‘only’ 114,000 net new jobs in July but paradoxically the unemployment rate still increased to 4.3%, the highest level since October 2021, as workers joined or re-joined the labour force. The problem was that expectations were higher than 114,000. US recession is round the corner!!

Market reaction

Investors got spooked, all of a sudden everything was going wrong.

By the time of the US employment data, Japanese equities had collapsed on the BoJ policy measures. Everyone had got very excited about a return to a strong economy and then all of a sudden the door was shut.

But then the wave turned into a tsunami as views shifted to the Fed leaving it too late to cut rates and a US recession became a real concern; if the US sneezes, the rest of the world catches a cold. The expectations for Fed policy moved almost as aggressively as they did at the time of the “banking crisis” and that had a knock on effect on other major regional expectations; markets rapidly discounted “emergency” decisions by the Fed and their peers.

Equity markets collapsed and bond markets rose; unsurprising, they had been riding high and a real threat to profits had arrived, but the scale and speed was extraordinary. There was volatility in gold, industrial metals and even crypto-currencies. We had entered a period of stress. Volatility spiked as seen through the VIX index which is a measure of the expectation of volatility based on S&P 500 index options, or, in other words, how investors view the current levels of risk. As you can see below, the last time it got to these levels was during the heights of COVID.

Source: Bloomberg 18.07.19 – 05.08.24.

A rotation in market leadership had been expected but the additional problems created a market rout. Bonds benefitted as rate cuts got priced in and the yield curve changed shape dramatically, with the short end falling, causing it to steepen. Credit spreads had been tight and widened as the recession fears built, as would be expected.

We must not forget that as we are now in ‘holiday season’, market trading levels naturally reduce as liquidity becomes a bit thinner across markets. We suspect that this is exacerbating the moves we are seeing.

The impact on the funds

The positioning had been the same for some time; relatively high in bonds, relatively low in equities, but optimistic overall. We saw where we were positioned within asset classes as just as important as the asset class itself. For example, we had been reducing the technology sector exposure in favour of more defensive companies and liked small cap.

Bond portfolio

The bond portfolios had a duration (interest rate sensitivity) which meant that we didn’t take full advantage of the changing expectations; we didn’t see this coming. However, the shift in the yield curve was of benefit. We are focused on high quality credit, so were less impacted as spreads widened.

Equity portfolio

The equity portfolio suffered in the sell-off, there was no place to hide. But, the UK weighting helped. The reduction in technology was a good thing and whilst small caps did better early on, they did get caught up in it. Providing numbers on how the portfolios have performed relative to benchmarks would be very out of date by the time you read this. Overall, we are happy with the structure we have in the equity portfolio, including the UK weighting. We were relatively inactive, it is very easy to get whipsawed in such markets.

Property company portfolio

The property company portfolio was interesting. Property companies should benefit from lower interest rate expectations and they held up well, but when you get periods of stress in markets, investors become indiscriminate, selling what they can. For example, German residential companies have secure revenue streams and benefit from falling rates, so they should be very defensive, but even they fell. We like the property exposure very much and this could provide an opportunity.

Alternatives & hedging

Exactly the same could be said for the alternatives exposure held through investment trusts, which held up well, then sold off as liquidity was sought.

In the hedging and defensives positions, we have been relatively light with the hedging, but we did adjust the protection after the market falls to be more sensitive. There are positions which benefit from volatility and momentum, which contributed and the tail risk protection remains in place.

Overall, it has been painful. However, prior to this we were comfortable with the asset allocation and each investment team liked their exposure. That remains the case. We were optimistic for the outlook but cautious in approach due to the risks that were apparent. Although we didn’t expect this.

A final thought

I think we are likely to see a period of elevated volatility across asset classes, this will include big moves up and down and also quiet days. But the volatility should reduce.

On the macro; the PMIs (Purchasing Managers Indices) are considered good pointers as to how economies will perform. A measure of above 50 is taken to mean economic expansion or growth and below 50 means contraction. The global manufacturing PMI has averaged below 50 through 2023 and over 50 so far in 2024. In July it slipped back to 49.7, which is hardly disastrous. The global services PMI nudged up to 53.3, still signalling decent expansion, although they have softened a bit. Overall, the global composite PMI has come back to 52.5 from the recent May peak of 53.7, comfortably in expansionary territory and certainly not predicting recession. Why not focus on those?

We remain vigilant and active on all areas of the funds, with the hedging being analysed hour by hour and adjusted as we see opportunity to do so.