How Managers Approach Risk: Part Deux

By the end of the first quarter, a financial system meltdown appears to have been averted —for now — by rapid regulatory action, including implicit deposit guarantees and bank securities lending programs to ensure adequate liquidity.

Policymakers seem optimistic that their measures to guarantee deposits will prevent a systemic crisis, and we generally agree that the global financial system is better capitalised than during the global financial crisis. In the benign scenario, the bank stress will pass but the tightening of credit conditions will remain, helping to do some of the Fed’s work for it and reducing the need for additional tightening.

However, taken together, the trifecta of strong growth, a tight labour market and higher-for-longer inflation would almost make the perfect argument for the Fed continuing to tighten.

Our expectation of a sustained period of below-trend growth, driven by a combination of tight monetary policy and banking sector distress means caution is wise. We expect growth near 0% for the rest of 2023 in the US, alongside a gradual weakening of labour markets that will combine to bring inflation closer to target this year, paving the way for full convergence in 2024.

We also expect market volatility to be with us for the next several months at least. So how can investors identify stocks with the potential to weather bouts of market volatility? We believe that a disciplined approach to buying high-quality, stable companies at the right price provides investors with multiple ways to mitigate risk while participating in market gains.

On a Practical Level, How do You Manage Risk in The Fund? Do You Have to Take More Risk With Asset Classes to Reduce Overall Risk?

High inflation is back and its impact can be devastating. Even at the European Central Bank’s targeted inflation level of 2%, a euro would be worth only 14 cents in 100 years' time. 

And with euro-area inflation now at its highest level since the 1950s, investors’ real purchasing power is falling fast. 

But here’s the good news: while no fund or asset class can provide a perfect hedge against inflation, there are solutions that may help blunt its impact.

Investment products that aim to provide an explicit hedge against inflation have pros and cons. For example, while index-linked bonds might seem like a default solution, they typically have low real yields and their inflation indexation may fall short of the actual increase in the cost of living.

Investors in liquid assets who want to preserve the purchasing power of their capital while generating realistic levels of income may want to consider:

1) equity shares of businesses that are likely to hold their real value over time, for instance through a portfolio based on quality companies that can raise their prices and grow their dividends to counter inflation;

2) high-yield bonds that have the potential to generate enough income to exceed inflation over time.

That means finding companies whose franchises are strong enough to give them pricing power, and/or issuers whose financials are robust enough to generate reliable cash flows and to maintain resilient balance sheets.

We believe that identifying companies with quality businesses can help position portfolios for long-term resilience. Features such as pricing power, competitive advantages, rational market behavior, innovation and management skill will define the companies that can overcome the profitability headwinds created by inflation and higher interest rates. Cash flows are an essential indicator of quality. Companies with high free cash flow have historically performed better through economic slowdowns and recessions. Healthy balance sheets and low debt levels mitigate some of the impact of rising interest rates.

Investors can also offset slowing growth with stability. Stable companies can cushion on the downside because they typically have lower beta — sensitivity to the broader market — than traditional growth firms. As with quality companies, fundamental research can unearth companies with hallmarks of stability across a broad array of sectors and industries. Firms like these are often seen in traditional defensive sectors such as healthcare, utilities and consumer staples, but can also be found in traditionally less-defensive sectors like technology, financials and energy.

On a Broader Level, How do You Understand Risk – And, on a Portfolio Level, is it Capital Loss, or Failing to Meet Investment Objectives? Is Volatility a Risk That Can’t be Avoided in Today’s Markets?

We believe equity portfolios designed to smooth volatility are especially appealing in the current market environment. We continue to look for companies that offer a combination of quality and stability at attractive prices, the three core elements that underpin our investment philosophy in good and bad times. For long-term, outcome-oriented investors, we believe that companies with these features are best positioned to deliver strong returns through changing environments.

Why stay invested in equities in this turbulent environment? Because equities remain a vital source of long-term returns even in economically-challenging periods with heightened market volatility. One thing is certain: it is extremely difficult to time market inflection points, and investors who try to do so often end up hurting themselves.

But why should investors want to own equities at all in a world of inflation, lower growth and increased volatility? After all, higher interest rates also make fixed income assets more attractive. And even if inflation settles into the 3%–4% range, the hurdles to positive real returns will be set higher.

Our answer is that investors need equity returns to beat inflation. In the past, equities have performed well during periods of moderate inflation, so as long as the current extreme levels of inflation prove transitory, stocks offer solid return potential, in our view.

Assets with explicit inflation protection, such as Treasury Inflation-Protected Securities (TIPS), won’t provide many investors with the level of return they need to meet their goals. And businesses that are well positioned for an inflationary environment can deliver cash flows that support positive real equity returns over time.