One thing we can usually rely on as investors is that things don’t all go wrong at the same time. If there are losers, there are generally some offsetting winners. We illustrate this with something we call a smarties table. It’s a grid in which each column represents a year within which each row shows the performance of an individual market or asset class. We assign a different colour to each investment to make it easier to see how they move up and down the rankings. Hence the smarties tag.
We’ve kept track of this table for many years, and usually it shows a wide variation of performances. In the best years, most if not all assets and regions deliver a positive return. Often there’s a mix of risers and fallers. Only very rarely (in fact I’ve never seen it) does absolutely everything lose you money.
This is why we diversify our portfolios. To ensure that we have exposure to enough pros to offset the inevitable cons. When performances are skewed towards the positive, with more and bigger ups than downs, maintaining a balanced performance over the years can be expected to deliver you a smooth and rewarding investment experience. You’re unlikely to match that student in America who made US$110m by effectively putting everything on red, but you’re unlikely to lose your shirt either.
Today, we’re in one of those unusual situations where the benefits of diversification are harder to achieve. What’s sometimes called the only free lunch in investment has been temporarily taken off the menu. Not only has the traditional balance between shares and bonds stopped working as rising interest rates have hit both assets at the same time. Geographically, too, investors are struggling to find a safe haven.
The challenges in the three principal investment regions - North America, Europe and Asia - are different but the market impact looks similar. In the US there is an inflation problem. In China the issue is growth. Europe seems to have got the worst of both worlds - a stagflationary mix of rising prices and a looming recession.
These diverse problems mean there is no one-size-fits-all solution. Tackling apparently intractable inflation will demand measures that more or less guarantee a slump. Supporting growth, on the other hand, can only let inflation run out of control. It’s Hobson’s Choice for policy makers.
But there is one thing that all three regions shares - a nagging sense that no-one has a firm hand on the tiller. It is hard to remember a time in the past when our political and economic leaders looked so impotent, events so out of their control. And there is nothing partisan in this observation. Whether you have a choice, in the US or Europe, or none in China, it’s the same story.
The catalogue of policy failures is long. In the US, the most important from a market perspective is the squandering of the Federal Reserve’s (Fed) hard-earned inflation-fighting credibility. Not since the Arthur Burns administration of the 1970s has the Fed got things so wrong. Jerome Powell’s new-found hawkishness at Jackson Hole last week only emphasised his over-confidence a year ago.
Elsewhere, Beijing’s handling of Covid does not inspire confidence in how it might deal with the slow-motion bursting of China’s long property bubble. In the UK, the prime ministers in waiting have spent the summer engaging in a futile argument about tax while the rest of the country wondered how they were going to heat their homes and feed their children through winter. With Italy’s bond yield approaching the point at which its gargantuan debts are unsustainable, Europe is looking into a different abyss.
What’s this got to do with our investments? Quite a lot, because investor sentiment depends on the intangible but powerful belief that there’s someone in charge who knows what they are up to. When trust and optimism evaporate, the downward spiral can become self-reinforcing. We are seeing signs of this breakdown everywhere. The inverted yield curve tells us that investors think that what the central banks are doing today will have a negative impact tomorrow.
For many years, since the financial crisis, it has paid to assume that the interests of governments, central banks and investors were basically aligned. Looking into a more challenging future that may not be the case. A better question to ask now is what investments we can make that do not require those in charge to make market friendly or even just good decisions.
So, the more defensive an investment is the better. If a company’s success is reliant on people doing what they have no choice about - to eat, drink, house and clothe themselves - it will be better placed to navigate the storm ahead. In the developed world, governments are generally unwilling to renege on their debts, so sovereign bonds will likely provide a reliable income and, if things get really tough, they may look like a safe haven.
Some trends are unstoppable and will not be blown off course by a short-term slump. Sustainable energy and electric vehicles fall into this category. The commodities that underpin these themes will remain in demand. Unpopular and untrusted governments will do what they must to stay in power, so expect them to spend where it makes them look good. And gold. It’s testing my patience, but it always does just before it is seen as the ultimate port in the storm.
One thing you can always rely on with our smarties table. No year ever looks the same as the one before or the one after. The free lunch should be back on the menu soon.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
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