Stuck In The Middle With You

27th April 2020

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Six weeks into our lockdown and equity markets find themselves roughly half-way between the lows they hit in March and the highs they hit in February. Both the pessimists and the optimists have been kept at bay by a market which has spent the last couple of weeks largely going sideways – unsure of the future direction to take.

This is hardly surprising, investors are seeking to balance two factors: Firstly, economic news that is dismal – worse than it has ever been. Secondly, a level of support from governments and central banks the likes of which we have never seen before. To put this in context, the US Federal Reserve has pumped into the system in five weeks the level of support it offered in the five years following the start of the Global Financial Crisis a decade ago.

These two charts tell the story. On the left the number of new people registering as unemployed in the US going back to the 1970s. On the right the size of the balance sheet of the US Federal Reserve. The vertical axis on this chart on the right is in trillions. It shows clearly that it took from 2008 until 2013 for the first wave of central bank support to reach the levels achieved in the period between February and April of this year.

Our convictions throughout this process have not changed. Ultimately the short to medium-term for markets will be dictated by the progress of this virus. When will the oil price recover? When they switch the economy back on. Stockmarkets recovered the first 50% of their losses when it became apparent the first wave of this virus could be controlled. For further significant gains to be made it will need to become apparent that the lockdown can be exited without a resurgence. In the meantime, it is a race to get to that point without seeing any major industries go bankrupt.

We are all aware that the broad news on this front has been positive in recent days with tentative steps being taken across Europe and the US to ease lockdowns. This certainly provides a meaningful tailwind for investors. In the United Kingdom of course we are still some weeks away and have yet to put in place the contact tracing and testing infrastructure we need.

In our view despite modestly improving news this is no time to significantly increase the risk we are taking in your portfolio. Why is this?

There are few absolute laws of investment management. However, a rule that is perhaps the closest thing to a fact as one can get is provided by Nobel Prize winning economic Paul Samuelson. He once wrote that stockmarkest were ‘micro efficient’ but ‘macro inefficient’. What he meant was that stockmarkets are good at solving complex small problems. For example, will Samsung or Apple sell more mobile phones next quarter? Probably analysts will pour over this question, get to roughly the right answer and put it in the price of the shares. Nobody will make much additional money trying to solve that problem more accurately than everyone else. It is this principle which has led to the ‘efficient markets hypothesis’ and the growth of passive investing. After all, if all information is public and share prices reflect both good and bad news then what is there to be gained by stockpicking?

However, and it is a massive however, stockmarkets are dreadful at solving big problems, complex questions on a ‘macro’ scale. For example, whilst they can predict short-term mobile phone sales and work out the relative benefits of each company, they missed entirely the fact that mobile phones would take over the world. The large complex questions such as which sectors will disrupt the world? Which companies will make whole industries redundant? What is the future path of inflation and interest rates? On these questions markets constantly flunk finding the right answer in the short-term. Ultimately answering these questions correctly is what enables investors to earn their active fees.

Right now, the market is trying to solve a huge ‘macro’ question. It is trying to work out what the impact will be of shutting and then re-opening the global economy for the first time ever, how our personal behaviours will change as a result of the virus and whether deflation or inflation will follow. Its chance of guessing this question right, and therefore the probability of market levels now accurately reflect the future world, are incredibly low.

For this reason, we are avoiding making binary choices. Our portfolios will remain carefully balanced across market factors, geographies, asset classes and risks so that whichever path markets take from here we know that we can cope and in time thrive again.

All portfolios that own shares are of course tilted towards optimism. In the long-term recovery always comes. However, for the time being it is just a ‘tilt’.

At the moment we are all stuck in the middle together. Taking a balanced approach at this juncture can be the only wise choice.  

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