War, inflation, hawkish central banks, and rising interest rates. It’s a nightmare recipe for investors, who must now tread carefully over the corpses of failed companies and discarded investment strategies.
The volatility in the market that has been gradually rising over the course of the past year looks to be hitting harder in 2023.
And while the ASX is stronger over the first few months of 2023 (although that looks to be changing), the volatility is likely to continue to cause havoc.
Addressing that volatility is key to a successful investment strategy – risk management, including diversification could be the key to feeling comfortable about investment decisions.
In this article:
Head of Risk senior portfolio manager at Atrium Glen Foster sat down with Proactive to discuss the current market environment and the importance of risk management.
Glen is Head of Risk Senior Portfolio Manager at Atrium and has over 18 years’ experience in financial markets, predominantly in strategic positions.
Interest rates and inflation
Australia endured its 10th straight interest rate rise in March. It was a first for the country, with the cash rate now sitting at 3.60%.
In the US it is 4.5% and likely to rise again.
US Federal Reserve chair Jerome Powell has foreshadowed a half-point increase, after economic data released since the Fed’s last meeting in January/February suggested the hikes were yet to sufficiently slow the economy to beat back inflation.
“Nothing about the data suggests to me that we’ve tightened too much – indeed, it suggests that we still have work to do,” Powell said. “It’s hard to make a case that we’ve over-tightened. It means we need to continue to tighten.”
In the UK the current cash rate is 4%, with analysts suggesting the rate will peak at 4.5% in the summer.
While it is likely 2023 will mark the peak of rate rises, it is just as likely the market will remain volatile until at least 2024 as individuals, communities, businesses and governments grapple with money issues.
Foster says these issues began a year or so ago.
“The story goes back to when the world started recovering from the pandemic. That’s when the first concerns about supply chain issues arose and it was obvious then that inflation would begin to bite.
“However, it may not have gotten out of control without the war in Europe as that created a lot of inflation in energy prices.”
Inflation has a direct impact on interest rates: rising inflation = higher rates.
Governments around the world have been trying to manage inflation back to their stated benchmarks. In Australia that is between 2 and 3%. Whether that is possible or not remains to be seen.
The problem is current inflationary pressures were transient but have become structural or long-term issues.
Transitory inflation occurs when expected temporary price gains are not part of a long-term trend. The American Institute of Economic Research defines the terms as a rate of inflation that does not remain high permanently and in some cases is followed by a period of lower inflation.
Foster says the pandemic made transitory inflation worse, particularly in the instances of food and energy supply and those issues are now ongoing.
“Structural deflationary forces are turning into structural inflation,” he says.
“During the pandemic there was a lot of talk about why inflation was really low and why central banks weren’t able to generate inflation by having rates at almost zero. It was because you had demographic forces such as ageing population. You had cheap manufacturing in China.”
There were a range of reasons interest rates continued to fall as governments tried to stimulate the economy.
However, in hindsight it may not have been the right play or perhaps governments took things too far.
Today, Foster says there are elements of deglobalisation. Governments are realising that they need to bring manufacturing back home or as close to it as possible.
China was once a cheap option but with a lack of supply local solutions are vital to keep economies going.
“So, they’re coming back the other way. That’s years of inflationary forces, decades, that will now play out. And it will be aligned with the cost of socio-economic policy, the transition to clean energy and a range of factors pushing prices beyond what they have previously been and to where they will stay in the long term.”
When you break down the costs of solar supply, the argument becomes clearer.
The cost of producing solar energy in the home is cheap. However, the cost of connecting it and making it the default energy supply is expensive. This is not a transitory thing.
The good news is if there is to be a recession it should only be minor.
“Inflation will probably bottom in a recession but will settle back to something that’s higher than before. That means rates are going to stay high and central banks will have very little flexibility to cut rates in response to economic crises.”
In some ways, what is happening today mirrors the causes of the harsh recessions of the 1970s caused by energy prices. Governments hiked interest rates to address the problem, which worked. But then just as the unemployment rates started to rise and the economy started to slow, they eased off and according to Foster they eased off too soon.
“Inflation didn’t spike again, straightaway. It took about three or four years. So, we had two recessions in the US within the space of four or five years and it was a really volatile period. That’s the risk we face now. If governments don’t get on top of inflation, we’ll revisit a period of real economic volatility.”
Today, the labour market is more flexible meaning governments are inclined to hit pause and see what happens. They have a bit more leeway. However, the guessing game between the wait and see approach, compared to the hawkish rate rise approach hasn’t been factored into the markets: they haven’t priced a really bad outcome yet.
How the market reacted and what investors should do
While the regulators may pause, it is unlikely they will ease up any time soon. The word is we won’t see interest rates fall for another year or so.
That’s despite markets factoring in cuts by the end of 2023. As Foster says, governments need to get the policy levers working and not risk reigniting inflation.
This is especially important as we are yet to see pandemic stimulus payments and their effect on the economy fully play out. These payments are yet to be exhausted.
With less cash running through the economy and markets remaining volatile as investors try to pick what governments will do next, investors must put risk mitigation strategies in place to manage their own economics.
“The most important thing to do is diversify,” Foster says.
“Asset allocation diversification is just thought of in terms of equities and bonds, both being long investment strategies. However, you can see from last year, this doesn’t always work. The problem is when the equity bond correlation goes positive and equities and bonds both sell at the same time, it tends to be at the time when you need diversification because equity is going down.”
Foster says investors should broaden their thinking beyond two sides of a balance sheet. Currencies and commodities are always in play. There is also the problem of lower cost, passive investment playing out.
“You can’t be passive in a volatile environment unless you’ve got a long-term horizon. You need strategy that makes sure you get paid for the risk you’re taking. You must have an active approach and be flexible with access across the markets.”
Flexibility is key but requires due diligence into supply and demand as well as the macro-economic cycle. For instance, China’s reopening should have a positive effect on commodities, however at the recent Chinese Communist Party Conference, the lowest ever economic growth target was set.
“China’s reopening should have been driving up iron ore prices, so trying to monitor what goes on isn’t straightforward. There are geopolitical and macro risks out there and you can’t just rely on one asset. You have to be a bit more robust to some different environments because we don’t know what’s going to happen. That’s how we manage risk.”
Know your focus
Volatility breeds change.
According to Foster, the next 10 years will bring an abundance of change and it seems we’ll move away from the macro-economic cycles we’ve come to accept as normal.
Regime change will occur. The next 10 years will look nothing like the last 10 years. The reactionary function of central banks will be different, and their approach will be different. Meanwhile, globalisation won’t disappear, but it will bifurcate and there will be a greater form of federalism.
It is those elements of the markets that advisors are now focused on and that investors must be focused on too.
Essentially, how do you manage risk in an increasingly risky and malleable environment.
It is in having a global focus, a worldwide reach.
“Australia is a very small market. It’s very concentrated in a few sectors. But the bond markets are even smaller, especially the corporate bond market,” Foster says.
“To diversify you first go to commodities. Then, the rise of trading platforms has seen better assets attracted to Australia and fund managers are able to set up established products that are new to Australia. The new ideas, the best talent, they’re things that are not necessarily going to be on your platform in Australia. If you have someone that has the network and the ability to implement, you’ll gain broader access to offshore vehicles and the means to deal with the complexities they bring.”
If investors do go down the fund manager path, they need to look for someone with a robust framework for making good decisions that is demonstrated by track record. Someone who understands the intricacies you may never have thought about when it comes to your due diligence in a company.
For instance, digital and cyber strengths – things you wouldn’t have thought of five years ago.
“You could have a shot at putting together a portfolio, but you wouldn’t necessarily know what the tail risks will be,” Foster says.
When considering your assets there are many questions to vet: what’s the tail risk? what if that blows up? what if all of these guys hold the same position? do you have diversity? what are all the risks that we get with the assets that we own?
“In fact, take a step back to the starting point,” Foster says.
“What resources do we want that are going to be rewarded and play a role in the portfolio. You’ve got to define what it is that you’re going to want to target and measure it. Then you’ve got to be able to monitor that over time to make sure you’re getting what you’re paying for.
“All that requires process systems and data and then you want to make sure that what you end up with is aligned with your risk objectives and ethics.”
In essence, Foster advises being flexible. Growth or defensive strategies don’t always make sense, so it’s important to throw off the shackles and the constraints and look beyond your safe havens.
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