The new year has started with stronger market returns that have offered hope to everyone that after the difficult years of Covid and inflation, better markets are now on the way.
Such hope, of course, is tempered by a natural proclivity towards scepticism which we believe our investors wish us to have. Whilst markets have recovered as growth has stayed strong and inflation has fallen, we have continued to monitor the remaining risks. Could inflation fall more slowly than hoped? Could the strength of the economy lead the world’s central bankers to believe that the economy can ‘take more pain’ and leave interest rates high until the last vestiges of inflation have disappeared?
Caution is good; it protects portfolios. But we must not be structurally bearish because over the long-term stock markets do generally rise, despite the short-term problems the world is constantly faced with. One thing is certain, it will always be possible to put together a case for being bearish at any given moment, and if we adopt this stance forever then our investors will miss out on long-term returns.
The evidence that inflation can be beaten without causing a significant recession has grown in recent weeks.
The US economy continues to add jobs at a surprising rate and here in the UK we see an economy which is undoubtedly toying with falling into recession but is nonetheless avoiding a significant contraction.
In simple terms, if the data continues at its current rate, with falling inflation and surprisingly strong growth, it sets the scene for a further strong period for markets. Bonds can rally as interest rates fall and companies can begin to estimate more optimistic earnings. We have the opportunity to pursue assets that offer stronger returns such as high yield bonds and smaller companies.
A key challenge for investors in this context though is where the real strength in markets will come from. Over the past year it is striking that really a small portion of the world has driven the vast majority of market gains. In particular US technology stocks, which have risen far faster than the rest of the US market.
The hope for optimists is that other markets and companies will have the space to catch up with these now expensive technology leaders as interest rates fall.
Indeed, we are starting to position our portfolios for this. Yet we do so cautiously. We acknowledge that the reason these technology names have been so strong is that they are unusually well-prepared to weather higher interest rates. They do not have to borrow money to fund their growth because they are so cash rich and their products are so rapidly growing in importance to consumers that demand is less sensitive to movements in economic growth than other goods and services.
So, our strategy remains to gradually turn into this recovery. If it feels to some that portfolios are positioning a little too quickly for a recovery and to others that we are waiting too long, then perhaps the balance is about right.
Each move of the portfolios to position for recovery brings with it additional risk, and additional sensitivity to companies and asset classes that can only thrive if the recovery does indeed come to pass.
Therefore, our philosophy is to be looking forward with optimism but treading onwards only slowly, with an unswerving vigilance to obstacles that could stand in the way of the strong absolute returns we are seeking for our clients.
The next changes investors can expect to see in portfolios, provided the current market patterns persist, will be an increased allocation to high yield bonds and a move to a more actively managed approach in undervalued stock markets such as Asian and Japan.
As our confidence in the recovery builds, so too will the conviction in our portfolio positioning.