Following the reprieve in July, markets returned to being volatile in August as the narrative of higher inflation and subsequent higher rates re-gained momentum. In line with previous similar periods, all asset classes sold off with the exception of Australian equities which generated positive returns driven by materials and energy sectors. In such environments where narrow parts of the market drive returns, portfolio diversification is less effective. However, we would argue that diversification remains your best line of defense over the medium to long term, as the likelihood of generating consistent long term risk adjusted returns by investing in a narrow basket of assets is low.
When markets are volatile it can be difficult to focus on the long term and on the positives. However, as we see risks associated with higher interest rates and growing geopolitical tensions amplify, opportunities do and will present themselves in such periods. As with previous market downturns, be it the tech wreck or the global financial crisis, market dispersion creates opportunity, particularly on an individual security level, as markets tend to indiscriminately sell off entire segments of the market irrespective of the quality of individual assets. In such environments we see the good, the bad and the ugly sell off, which has been the case with the technology sector where companies with high debt and ‘promises’ of earnings sell off, alongside companies with strong balanced sheets and strong growth profiles.
Similarly, on an asset classes level, as assets reprice, asset classes that were previously unattractive on measures such a valuation, now deserve another look. A good example of this are bonds. For the best part of 10 years government bonds have been unattractive offering low yields and looking expensive on all valuation measures. This dynamic was fueled by central banks suppressing bond yields via measures such as quantitative easing (QE) coupled with the fact that inflation was non-existent. Roll forward to today and bond yields are above the 3% range, inflation is back and central banks are stopping or tapping on the brakes on QE. Therefore, the forward-looking risk return profile for the asset class is looking very different than the prior 10 years.
We expect volatility to remain with us for the coming months. Key central banks have been clear that they will continue to raise rates until they see evidence of inflation subsiding. The risk of a global recession is elevated as the lagging impact of higher interest rates are yet to come to the fore. From an Australian perspective the composition of the Australian economy, which is heavy on energy and materials, is expected to buffer Australia to some degree from a deep recession and our base case is that if we do go into a technical recession, it will be mild relative to other regions.
As market participants, thinking about the ‘x-factor’ risks is important. In the coming months, outside of inflation the thing to watch will be energy security, notably in Europe as the northern hemisphere winter approaches. The Russian invasion of Ukraine has had a material impact on European energy security, and we have witnessed key European economies look to pivot quickly to sure up energy for the winter, ranging from turning coal plant back on, delaying closing down nuclear plants through to finding alternative energy providers. Germany has already signaled that if they have a strong winter, they may need to ration energy and slow down industrial production to ensure households have enough heating. Such a scenario would further exacerbate the economic slowdown in Europe and would have implications for markets.
Change and transition is never easy and we are going through a significant change in the global economy and markets at the moment. It is a time to be vigilant but also a time to keep a long-term perspective, consider the facts, lean on your investment process and leverage people’s market experience.
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