Central banks are walking the tightrope hoping to deliver a soft economic landing with a benign inflation outcome.
Developed market equities have experienced a torrid start to the year and private investors are worried. The metaphor has gone from stock (and crypto currency) tips from your taxi drivers to recession predictors from your UBER driver.
Private investors need to remember that there are long term secular trends that will continue to influence the flow of capital and investment returns. After being artificially suppressed for many years by policy stimulus, the business cycle of greed and fear that has driven regular periods of boom and bust is now returning.
The role of risk profiles has been a cornerstone of the financial advice industry for many years. Risk profiling is a process advisers use to help determine the optimal levels of investment risk for clients. It aims to identify the risk required to meet a person’ investment objectives, risk capacity, and tolerance to risk. Investors should be comfortable with the amount of risk they have in markets and can live with the drawdowns that inevitable come.
The reality is that many investors will be reviewing their negative returns from markets in 2022 with a sense of bewilderment. The somewhat unusual underperformance of the both the equity and bond markets at the same time has seen a traditional balanced portfolio perform poorly. Investors may have not fully appreciated the level of risk they were carrying in their investment portfolio. Equity allocations have been creeping up for years as capital market forecasts dictated higher allocations to risk assets in the hope of meeting real return targets.
Psychologist Amos Tversky and Nobel Prize winner Daniel Kahneman found that investors feel the pain of a loss twice as much as the joy of an equivalent gain. This is called ‘Loss Aversion’, and it means that investors hate losing money far more than they enjoy gaining money. Feeling uncomfortable about negative returns is normal human behaviour, however as I wrote last month, doing nothing is not a viable investment strategy. Investors can use this as an opportunity to assess their level of comfort with recent losses and whether their risk profile, fits their tolerance for drawdowns. As Mike Tyson famously said – ‘Everyone has a plan ’till they get punched in the mouth’.
In an attempt to educate investors about investment risks, APRA introduced 7 standard risk measures for superannuation products to give investors a common basis for comparing strategies. The measure is based on the number of negative annual return years a strategy can expect in a 20-year period. A typical balanced strategy would be expected to have 5 negative returns in 20 years while a straight equity portfolio can be expected to have an average 6 negative annual returns in a 20-year period. This would no doubt surprise many new to investing.
Many commentators are now drawing parallels with the period of 2001 and 2002 following the “Tech Wreck”. No revenue and high multiple businesses have been punished. Flows out of equity markets have been significant over the past year, sentiment indicators are at reasonably bearish levels, and major technical support levels feel well below the prevailing market level. In this environment it is difficult to judge when markets bounce and whether we have reached a turning point or just another violent bear market rally.
The fundamental question being imposed on markets is what level of interest rates will be required to bring inflation levels back into central bank’s target ranges. Many pundits are arguing that cash rates will have to go way above neutral to soften demand and bring more balanced demand to product and services markets. The pace of quantitative tightening through central bank balance sheet reduction is making this cycle way more difficult to judge.
The chance of a policy mistake is high. But central banks do not seek to create recessions. Despite the market spending its time trading every nuance, central banks have a broad picture in mind as to the path of interest rates - in the US this is indicated by the dot plots. But each policy meeting will always be live and heavily data dependant. Understanding the reaction function of central banks will be important as they weigh up the risk reward of action against the consequences of making a type one or type two error. Central banks will be walking the tightrope hoping to deliver a soft economic landing with a benign inflation outcome. And private investors will be hoping they can deliver engineer the goldilocks outcome in order to avoid one of those dreaded negative return years.