The Right Time for Multi Asset Investing
The painfully low interest rates and volatile stock markets we have seen in recent years have caused many to question the point of investing. For barristers, who face additional uncertainty over the incidence of their income relative to those in the salaried professions, taking risks with hard-earned savings must seem particularly unwelcome. Keeping everything in deposit accounts is not a sensible long term strategy as the purchasing power of money can be eroded by unanticipated inflation. The problem is the investments most likely to beat inflation by a wide margin over the long run tend to be riskiest in the short run. What then is the solution? I would argue multi asset funds have an important role to play in maintaining exposure to the right asset classes to meet long term objectives while going some way to controlling risk through diversification. These funds are particularly appropriate at a time of short, violent economic cycles such as this as different assets in the mix tend to do best at different times.
Equities can be expected to offer high returns over the long run as compensation for the high level of risk the owners of companies take on. When the economy takes a turn for the worse, however, this risk can manifest itself in the form of capital losses. Stock markets can also move sideways over fairly long periods as the current generation of investors knows only too well. The FTSE100 index of the largest UK companies is not far from the level it first reached when Tony Blair came to power in 1997.
Spreading your investments across a range of asset classes can help. A well-diversified portfolio of stocks, bonds, commodities, property and cash would have offered only a slightly lower return than stocks over the last thirty years with about half the level of volatility. Moreover, as there are evidently good times and bad times to hold each asset class a good portfolio manager should be able to boost returns further by adjusting the asset mix as conditions evolve.
At Fidelity we use an Investment Clock approach to help us position the multi asset funds we manage. We find that most if not all the major turning points in markets coincide with turning points in the world economy that generally aren’t apparent until much later. Stocks peaked in mid 2007 when the world economy was dragged into a largely unanticipated credit crisis Bank of England governor Mervyn King has called the worst since World War I. The sharp recovery in stocks since March 2009 coincided with a rebound in the world economy which was by no means obvious in the initial weeks and months. We have investigated the link between the world economy and the markets in great detail over the years. We find that a particular asset class tends to offer its best performance at a particular stage of the economic cycle, defined with reference to the strength of global growth and the direction of inflationary pressures. There are also some reasonably consistent patterns at the equity sector level, as summed up in the Investment Clock diagram.
The Investment Clock diagrm
Deciding which phase of the cycle we are in at any given time is much more difficult than it sounds. Economic data is backward looking and it’s often not possible to be absolutely sure what is happening until long after the event, by which time the markets have already moved. We track our own growth and inflation indicators month by month to help us understand where we are and, more importantly, where we are likely to be heading in the next few months. Plotted on the axes of a two dimensional chart, we can see how the economic cycle is evolving.
Where are we in the economic cycle?
Right now, the near term economic outlook is not promising. The pace of the recovery is likely to slow over the next six months and, human nature being what it is, fears of a relapse are likely to intensify as weaker economic data come in. I am optimistic growth will re-accelerate in 2011 but in the meantime I have shifted some money out of stocks into more defensive government bonds in the expectation that I will be able to buy equities back again at what should be attractive valuations later this year or early next.
To understand why growth is likely to slow you need to understand how the industrial inventory cycle works. Business confidence is running high and companies are reporting bumper profits but industrial production has caught up with and exceeded the growth in final demand. Factories will soon be forced to reduce their output as stocks of unsold goods accumulate and this will have a knock-on effect on employment and consumer confidence. The ebb and flow of the inventory cycle is relatively predictable but market participants find it impossible to distinguish a harmless cooling off in the pace of growth from the early stages of a double dip. There are always compelling reasons to fear the worst so the markets worry about recessions far more often than they actually occur.
Positioning your portfolio ahead of these swings in sentiment can be very profitable. Global inventory cycles last about two years in total and it is for this reason that even numbered calendar years have been so bad for equity investors over the last decade or so. The pattern is striking. Since January 1998, global equities have returned 60 per cent in US dollar terms. The cumulative return over the even numbered years, coinciding with inventory gluts, was a drop of 35 per cent. Odd numbered calendar years, on the other hand, enjoyed cumulative returns in excess of 140 per cent as factory output rose to replenish inventory levels and corporate profits surged.
It seems 2010 is proving no exception to what you might call the even years curse. Stock prices fell over the first half of the year and UK government bonds are doing well as growth slows once more. I believe fears of a prolonged downturn will prove unfounded. Ample spare capacity and high unemployment rates in the large developed economies are exerting downward pressure on inflation – even in the UK where, if it weren’t for fluctuations in VAT, consumer price inflation would be well below the Bank of England’s two percent target. Against this backdrop and in the face of significant government spending cuts, central banks will be quick to step in with further stimulus as growth forecasts are revised lower. Printing money may be unconventional but it certainly seemed to work in 2009 and I think it will work again. Companies will find themselves having to switch production back on again as final demand recovers, setting the scene for renewed equity market strength in 2011.
Recessions are, thankfully, uncommon events and economic expansions lasting five years or more are the norm. I think we’re still in the early stages of what will be a multi-year bull market in equities but volatility will remain high as economic uncertainty persists. Keeping all of your savings in any one asset class will not feel comfortable as the cycle moves rapidly from one phase to the next. In uncertain times, multi asset investing can offer much needed stability.