Quarterly Market Update: The Positives of Volatility

Talking to our fund managers, as we regularly do, reminds me of the positives. While many of our fund managers note the challenging environment, more are excited and enthused about the opportunities the current environment brings – fundamentals such as valuations become more attractive in such a market environment vs that of a boom, and it is exactly this type of environment where active managers tend to add the most value.

Fixed Income (FI) has been particularly under the limelight lately. Typically a diversifier against equities and an income generator, FI seems to have played none of these roles. How to make sense of this?

Rising inflation has been a major theme this year. With long-term inflation targets generally at around 2% for most central banks¹, headline rates venturing into double digits for some economies are the stuff of nightmares – above all for central bankers. Said central bankers respond primarily by accelerating the rate at which they’re increasing interest rates – the main tool they have to get to their target. The US Federal Reserve has hiked its federal fund rate five times this year already, with 3 “jumbo” rate hikes of 0.75%², while in the UK, the BoE has been increasing it by 0.5% for the last two months following five hikes of 0.25% in the last 12 months³. When rates increase, the inverse mathematical relationship between the bond prices and interest rates means that FI valuations fall.

The aggressive US response, in particular, has seen shares struggle – particularly hurting growth-style stocks such as tech. This is very much valuation related too, combined with that the tech sector tends to underperform during high inflationary periods. Given the dominance of tech stocks in major world indices over the last decade – 5 out of the top 10 largest companies by market capitalisation are tech companies – the impact on stock markets is not surprising⁴.

This highlights the importance of diversification of investment styles between growth, quality and value.

The Fed’s tightening policy has also kept the dollar strong over much of the period, even achieving parity with the Euro at one point. Whilst we fully hedge fixed interest into our clients’ respective base currencies to help ensure we match your longer-term goals, currency fluctuations will still impact portfolio, and fund performance from a valuation perspective, e.g. returns of GBP-based funds and portfolios may appear stronger relative to returns of USD based portfolios during times of a weak GBP and strong USD, simply due to the movement of these currencies and the global nature of our equity exposure (assuming all other things being equal).

It’s been interesting for us to note that whenever reported inflation figures pose a surprise on the upside, any assets that typically protect from inflation, such as property, commodities and equities, are being sold off. This would make sense on the assumption that central banks will continue hiking interest rates without limit no matter how high inflation gets in order to bring it back down to their targets.

In reality, however, weakening economic growth, financial stability risks, as well as high debt levels may give the world’s major central banks varying degrees of challenges in this fine “balancing act” to fight inflation and sustain longer-term growth as well as conflicting political agendas. This was illustrated by last week’s Bank of England market effective quantitative easing intended to prevent an imminent pension industry crisis; the latter, as we all know, was triggered by new chancellor Kwasi Kwarteng’s fiscal plans of cutting taxes that led to worries about debt sustainability causing government borrowing costs to spike, while the Pound fell notably in value relative to other currencies, reaching just US$1.04 at its lowest point before recovering.

The UK has not been the only country experiencing sharp currency weakness of late. However, Japan is leading the way in Asia against the backdrop of the Bank of Japan remaining a lone holdout regarding dragging its feet on tightening actions.

Is it all doom and gloom? Possibly not. Many will have likely jumped at the chance to make a few bucks on the cheap Pound last week. We see the same opportunities across the space and over a longer time horizon. Taking Japan as an example, valuations currently sit at the very bottom of the historical range, whilst the low Yen may support Japanese companies’ competitiveness in the coming years. Moreover, Japanese household savings on average, are overweight on cash/deposits and underweight equities, and the government is set on incentivising a shift from the former to the latter, putting monies to more productive use. These factors, along with the ratification of RCEP (Regional Comprehensive Economic Partnership – the world’s largest free trade area) at the end of August, may bring significant trade benefits to the country and region.

So, while the sea of red in the valuation reports may be unsettling and may make us want to crawl under the cover and bring all our investments there too, history has shown that this would be mostly a rash and emotional decision without long-term merits. One only has to look back a couple of years, to the depths of COVID-19 in early 2020, to see an example of how, once a recovery starts, its pace can catch the market by surprise. The opportunity cost is even greater where one may be missing out on the additional values brought by the new opportunities that come with volatility.

Therefore, it is important to block out as much of the background noise as we can. Instead, take a step back, keep calm and think about the objectives we are trying to achieve.

Of course, staying calm is easier said than done in a world of 24/7 connectivity. Dramatic headlines seem to be omnipresent. Often though, when we actually look at the data, the reality is much more mundane.

Ultimately, the most important thing is to focus on your goals, ensuring that you have the right strategy. And this is one of the key aspects where financial advice can really provide value for you – your Partner can help you cut through the noise, focus on the fundamentals and stay on the best path to meet your objectives.

For our part, our investment beliefs provide us with a framework for decision-making and stand us in good stead in the face of wider economic challenges as we look to help you build your financial well-being on a long-term basis.

Past performance is not indicative of future performance.

The value of an investment with St. James's Place will be directly linked to the performance of the funds you select, and the value can therefore go down as well as up. You may get back less than you invested.

An investment in equities do not provide the security of capital which is characteristic of a deposit with a bank or building society.

Sources
¹ Federal Reserve: Why does the Federal Reserve aim for inflation of 2 percent over the longer run? – August 2020
² Federal Reserve FOMC statement – September 2022
³ Bank of England: Bank Rate increased to 2.25% - September 2022
⁴ CompaniesMarketCap.com