Investment Matters

Being proactive (in a reactive market)

The rollercoaster we witnessed on the ASX this week left us with a sense of Déjà vu.

Only two months ago we saw the market fall by 3% over the space of a week only to stage a quick recovery (see A round trip on Wall Street).

This week felt eerily similar for two reasons.

Firstly, the market fell by 2.5% early in the week, only to stage a quick recovery by Thursday (subsequent to writing this article we saw the market fall by 2% on Friday!).

Secondly (and more importantly), the prospect of higher interest rates was the key driver.

This once again illustrated the fragility of an expensive market to changes in the fundamental assumptions that underpin prices: ‘lower interest rates for longer’ and ‘transient’ inflation.

In hindsight, this may prove to simply be a ‘blip’ in markets.

However, the volatility that we witnessed emphasised to us the importance of building portfolios that proactively consider the potential for change, rather than reactively respond to them.

The trigger?

Much like in July, the jump we saw in bond yields coincided with the meeting of the Federal Open Market Committee – the twelve-member committee responsible for setting monetary policy in the US.

Three things were in focus.

Firstly, the committee signalled it is all but certain to begin withdrawing the massive support that it has given to keep long term interest rates lower.

Secondly, it raised its forecasts for inflation – expecting current ‘transient’ above-average inflation to last until 2024.

Lastly, it indicated it expects to raise short term interest rates faster and sooner than expected.

The chart below illustrates just how rapidly their thinking has changed over the past year.

The dots indicate the interest rate forecast of each participating member.

As the chart shows, expectations have moved from no rate rise over the next four years to a unanimous consensus that short term interest rates will begin to rise in 2023.

Picture1

Source: Financial Times

This was a tacit admission that inflation pressures are likely to be here for longer than expected.

Later in the week, the chair of the Federal Reserve stated that inflation was persisting longer than expected and that if sustained the Federal Reserve, “would certainly respond and use our tools to assure that inflation runs at levels that are consistent with our goal.”.

These tools primarily consist of one ‘big hammer’ - raising interest rates.

The reaction by the market over the week was a microcosm of what we may see should this eventuate. 

The reaction

The reaction to the news over the week is illustrated by the charts below.

It provides an insight into how prices may react should interest rates continue to rise and inflation persist longer than expected.

We contrast these movements to how clients of First Samuel are positioned.

Long term interest rates: a unanimous rise

10 year yields

Source: First Samuel, IRESS
Shares: Value beats Growth

Value beats growth

How our clients are positioned: A large percentage of the stocks clients own generate good levels of cash today (as opposed to promising to deliver cash in the future) and can be considered ‘Value’ stocks.

Furthermore, clients’ international holdings have a tilt towards ‘Value’ markets (Europe and Japan) as well as less exposure to ‘Growth’ stocks in the US.

Shares: The Technology Sector slumps

Tech slump

Source: IRESS, First Samuel

Aus tech

Source: IRESS, First Samuel

How our clients are positioned: Client portfolios own companies that will benefit from improved productivity from changes in technology. The ‘pure technology’ exposures that they have, in contrast to the broader market, are cash generative.

Property securities: A firesale
Property securities firesale
Source: IRESS, First Samuel

How our clients are positioned: Clients Property Portfolios are conservatively positioned. They hold cash, property debt and a weighting to property managers that look to add value through improvements and opportunistic purchases (versus accumulating assets at prices underpinned by low-interest rates).

Income securities: Newton’s Third law

Newtons third law

Source: Bloomberg, First Samuel

Bond prices are the inverse of bond yields. Therefore, as bond yields have risen bond prices have fallen. This is illustrated above: the Bloomberg Ausbond Composite 10+ Yr Index, which holds bonds with a duration of greater than 10 years, has fallen by 3% over the past week. This is significant seeing as these securities yield approximately 1-3% in interest per annum.

How our clients are positioned: Clients hold portfolios that are short in interest rate duration, that is, that look to minimise the negative impact of rising interest rates.

Where clients are invested in longer-term debt, they are invested in a diversified group of higher yield instruments that take on possible credit risk rather than guaranteed interest rate risk.

Takeaway

This week provided a reminder of just how quickly the market can turn when fundamental assumptions about interest rates and inflation are challenged.

In our view, when constructing portfolios to protect and grow wealth, it is better to proactively consider what may change and position for it.

Simply ‘reacting’ when change arrives is akin to playing a perilous game of musical chairs, as evidenced by this week’s market movements.