It is striking how investors reading research reports produced by a variety of market participants, especially on the sell side, could have easily come away with the impression that until a week or so ago, there was nothing much to see in markets. Yes, they were down; yes, rates were going up; yes, inflation was a problem and so were energy prices, but a recession was surely not going to happen.
Investors were reminded at every turn that they never must stray from their equity allocations and if buying the “dip” wasn’t outrightly advocated, at the very least investors were admonished for contemplating the idea of reducing their exposures. Stock market declines were nothing but a garden variety correction, and the “smart” thing to do was to stay the course. The arguments put forth were at times masterpieces of intellectual gymnastics, always written with an air of superiority (dare we say condescension at times…) to ensure the brave readers wouldn’t abandon lucrative positions (no custody fees on cash…) or would continue to trade the newest, shiniest idea (must keep those trading commissions flowing…), of which there seems to be a never-ending stream.
It has been almost humorous to see how recommended equity allocations have been reduced in single percentage point steps (because a change from 46% to 45% really moves the needle), were it not for the fact that these recommendations have real-life consequences for the wealth of investors. Similarly, recession forecasts went from impossible, to highly unlikely, to maybe, to probably, to “we are now in serious trouble” in small and digestible steps which would prevent hasty reallocations of portfolios. Sadly, this all very much felt like business models driving recommendations rather than common sense and is reminiscent of what happened in 2008 and previous sell offs where few advisors were willing to express a view and prepare for what they felt was a realistic, but ugly scenario.
If we take a step back, it should have been obvious that we were heading for problems, and not just in recent months but as early as 2019. Valuations back then were already toppy, and it was hard to justify rationally why and how markets should continue to head in just one direction. Of course, the COVID-19 pandemic, and the resultant opening of the liquidity spigot meant more fuel was added to the flames and investors were all too happy to join the sugar rush, but as any parent will tell you, this always ends in tears. The endless stream of get rich quick schemes and questionable assets that turned day traders into millionaires, and Roaring Kitty into the newest Wall Street guru should have been enough to worry even the most blue-eyed novice investor.
In the wake of COVID, how could excessive spending on holidays, flights and luxury goods — the queues snaking in front of the designer stores in Zurich on the first day of post lockdown reopening had to be seen to be believed — coupled with a war, supply chain disruptions and increased energy prices not create a problem? How could all of this be positive for corporate earnings and valuations? How could this not have repercussions for consumer spending and the resultant drop in household wealth and negative wealth effect not ultimately impact consumer confidence?
It seems startling, at best, given this tsunami of negative indicators, that market participants only now seem to have woken up to the fact that all is not in order. While no one has a crystal ball, it has seemed prudent for some time to avoid high net exposure equity managers, traditional fixed income and illiquid investments. A focus on diversifying, non-directional strategies, together with capital preservation is a lot more reasonable in a world beset with extremes, uncertainties and a paradigm shift from lower rates and almost unlimited liquidity to higher rates and a dearth of liquidity. While the mantra before was “lower for longer” it now seems to now be “higher for longer.”
The question now confronting investors is whether the new emerging consensus about higher rates for longer is just as flawed in light of rapidly contracting economies and potential buyer strikes. Will rates really be able to stay high for long should economies convulse? Neither scenario seems to bode well for risk assets and high beta exposures in the short term. However, if there is one thing that is certain, it is that this too shall pass and new opportunities will arise from today’s doomsday scenario as they have always done in the past.
Staying liquid, solvent and able to take advantage of these opportunities as and when they arise will be the key to long term prosperity for investors. In the meantime, it makes sense to focus on diversifying strategies such as global macro, CTAs (via baskets rather than single exposures), as well as relative value, instead of taking directional risks. True equity market neutral (meaning factor and sector neutral), should also benefit from a returned investor focus on fundamentals and away from speculative future profits.
Increased short term yields also present an attractive option to lock in some “risk-free” returns for the first time in a long time buy buying quality bonds, and this certainly is raising the bar for investors considering other asset classes. While such bonds may not beat inflation, they should be a lot more attractive in the short term than potential further downside in risk in equities. As always, this crisis will undoubtedly lay the foundations for the next big opportunities.