The recent market setback is a concern to many. With the potential of a trade war, rising interest rates and late cycle economic nerves, it is little wonder investors feel flighty. But is this the onset of something serious? Is it even justified? What opportunities – if any – may it create?
As an effective starting point, we must ascertain whether the collective knowledge of the market is a true reflection of reality. Specifically, against a backdrop of typically intelligent and motivated people on each side of a trade, every investor should question what is knowable and unknowable.
On one hand, lofty valuation pressures and the threat of a trade war have been clear for some time, although these were largely “known” and something many investors willingly accepted. On the other hand, the world carries ever-present and shifting uncertainties, much of which is “unknowable” and dependably unpredictable.
If we think of the recent setback and link it to human behaviour, it appears much of the decline may be attributable to its own behavioural weight. Said simply, the pendulum of fear and greed has a habit of exaggerating market cycles – against what is known as well as unknowable – and the recent setback is more likely to reflect an unwinding of excessive optimism rather than anything fundamental. This is not to say that fundamental concerns haven’t shifted gears – they always do – but rather to acknowledge the underlying source of the demise is likely behavioural rather than foundational.
Are There Any Pockets of Weakness?
One clear pocket of weakness has been in the UK. Brexit uncertainty, sterling strength and some downcast economic activity are all weighing on sentiment. This is most prominent for the FTSE 100, which continues to attract a lot of attention for its poor run. By numbers, it is now down another 2% in March, meaning it is now down just over 7% year-to-date and virtually flat over one year.
The performance is considerably worse than the domestically-focused FTSE 250 as well as its European equivalents, carrying the features of meaningful divergence. Yet, corporate earnings among these 100 companies continue to improve in the majority of cases.
Furthermore, the weakness in the UK is by no means insulated. In fact, the global all-share universe has experienced widespread falls too, down by more than 4% in March alone in sterling terms, and has also wiped out a material portion of its gains over the past year. Beyond the UK, we have seen parts of Japan, Europe, emerging markets and the US all contributing to the pain. Loved sectors such as technology have come under fire amid regulatory concerns, whilst unloved sectors such as telecommunications continue to hurt. All paintings are getting a broad brush, just with slightly different strokes – bringing us back to behaviour and the potential for mispricing opportunities in time.
Fixed income has similarly come under fire, although some parts of the market are proving their resilience amid a flight to safety, UK gilts were up 2% in March in sterling terms. Government debt is the primary asset class that continues to divide investors, with generally unattractive yields balancing against potential diversification benefits. Of note, the speed of US interest rate “normalisation” has meaningfully changed the reward-for-risk among US Treasuries, creating better value in this space.
Riskier bonds are not subjected to the same fate, with credit spreads still hovering near cyclical lows and more vulnerable to a downturn. High yield debt generally struggled in March as credit spreads edged higher, while investment-grade debt saw subtle gains in local currency terms. Emerging market debt was another area in the spotlight, with local currency issuance hampered by currency volatility but generally resistant to the threat of a trade war.
Are Markets Now Cheap?
As advocates of contrarian thinking, it is important to contemplate where that leaves us. Are markets now cheap? Or just less expensive? By focusing on the long-term drivers of returns, we find it to generally be the latter, although some pockets are now far more attractive than others. Of course, Brexit and trade tariffs will play a part in the shorter term. However, we are most interested in controlling risk and managing the portfolios holistically so that they stand up to many scenarios, not just one.
Ultimately, one should not be surprised by the market setback. Furthermore, one should not be surprised if further panic ensues, the herd mentality and loss aversion make this distinctly possible – albeit in the short term it is anybody’s guess. When faced with such circumstances, it is important to remain calm and to focus on what matters, which invariably brings us back to a) long-term valuations, b) long-term fundamentals and c) controlling our behavioural urges. This is what sensible investing means to us during times of market distress.
