The three things I would tell my clients this week.
Stocks have momentum and the economy is slowing less than expected. But risks are simmering in the background. That's why we chose to moderately reduce risk.
High rates may persist, and something else (other than some problematic banks) could break. This is an increasingly illiquid market, and therefore not a bull market.
In a sideways or a bear market, good performance of risk assets is reason to take some profit and put money to work at better valuations.
Investing money at a time of volatility
A few days ago, our Investment Committee decided to reduce risk exposure. Yet, ostensibly, the economic and financial environment is improving. Equities have a positive momentum, the economic slowdown is much less worse than originally anticipated, headline inflation is coming down and central banks are near the end of rate cuts. So far, China’s reopening is contributing to growth but not inflation. In normal times these signals could have reason to increase risk exposure, not reduce it. But these aren’t normal times. Because we aren’t in a bull market. And that means we need to think differently.
Our key theme since the beginning of the year is that the world is a volatile and unpredictable place. To be fair, this could have been our theme every year since 2006 and we would have still hit the mark.
But this is not garden variety volatility. Underlying everything are two themes. A big geopolitical shift away from the post-soviet unipolar world, and the war against all that is not sustainable.
America is gradually abandoning its role as the world’s sheriff, a role that has cost it friends. It is a trend that began in 2008 and accelerated since. Like Britain, Spain, France, or even Rome before them, American leaders discovered that the world is too big a place to control, even with modern technology. If there’s one thing power hates is a vacuum, challengers to US primacy and the Dollar have been rising, and banding together. As the world is moving back from unipolar to bi-polar, supply chains need to readapt. It’s harder than it sounds. Factories moving is the easy part. To construct modern goods, anything from electronics to EV vehicles, raw and processed material from all over the world is required. Self-reliance of each block depends on successfully rebuilding vast and complex supply chains, quicker than politicians can break the trade binds forged by globalisation. As the two interdependent economies, the US and China, decouple, the consequences are felt across the globe.
This is a world inherently uncertain. And this uncertainty is not cyclical. It’s not about emotion. It’s about structure. So uncertainty is structural.
Meanwhile, the world is trying to transition towards sustainability. Terraforming of that scale hasn’t been attempted again, and how we get there is still uncertain.
Now imagine an economy that produces 120 units of a good, let’s call it Goodium. Goodium is the one good that sustains life, entertains and gives meaning at the same time. It has no substitutes. Demand for Goodium is 100. All is good, and inflation is not an issue. But demand grows, as people from other economies (like Asia) start wanting Goodium. At the same time, supply chains become less efficient. Now production of Goodium is less than supply. Prices go up.
Goodium is just a metaphor for “all products”. Because changes like that affect all products and all supply chains.
This is a world inherently inflationary. And because lack of supply is not transitory but the result of bigger processes, inflation is not cyclical, but structural.
Central banks now have a difficult task. They know that supply chains are not functioning optimally, and that’s not something they can fix. So, to bring prices under control and prevent spirals, they need to bring demand down. But how can you reduce demand for everything, and for a long time at that? Only by reducing disposable income. The process of making people poorer is a very painful one.
In a world where things are structurally uncertain, higher inflation and persistently high rates are the base case scenario. The mini-banking crisis may be over (?) but higher interest rates tend to uncover more areas of weakness fostered by an unusually long and liquid cycle.
So while short term signals are good, the larger forces at play, and lack of a clear catalyst for the next bull market forces us to see the uptick as cyclical. The basis of investment is mean reversion. In a bull market, mean reversion means return to an upward trend. In a volatile and trendless market, mean reversion means return towards a sideways trend. A bullish signal in a bull market is a buy signal. A bullish signal in a trendless market is a caution signal.
Investing like this requires discipline. It compels us to constantly question ourselves whether we are in a bull market, a bear market, or -as we think is the case- a volatile market in search of long term drivers. All signals should be seen not in isolation, but under that particular prism.