Markets have had a horrid start to 2022 and that was before Ukraine came to centre stage. What to do? Before we answer that let’s reflect a little. “Deep in the human unconscious is a pervasive need for a logical universe that makes sense. But the real universe is always one step beyond logic.” Frank Herbert – Dune
“It doesn’t become the truth just because you believe it. It’s a sign of wisdom to avoid believing every thought that enters your mind. It’s a sign of emotional intelligence.” Adam Grant – Think Again
Two quotes to reflect upon that might help us think about how we think about the world from both a personal and market perspective; in fact, they are both the same thing, and we can boil it down to behavioural conditioning.
Our opinions on Ukraine, central bank monetary policy and geopolitical and economics in general are just that; opinions held as a result of conditioned beliefs. The fact that different people can hold opposing views is exemplified by the “I’m right, you are wrong” syndrome, which usually results in conflict of some kind. Ukraine being one very good example and the struggle between the bulls and the bears in the markets being another.
In truth neither side is usually right but try convincing them of that! Removing emotion from the decision-making process is very hard indeed, but as successful investors that is what we must strive to achieve.
When we are confronted with a new and potentially dangerous scenario we are conditioned to “do something”. We are about to cross the road and we observe a lorry careening towards us. We orient towards our experience and understanding that this is potentially dangerous, so we decide to act or in this case not to act by stepping back from the kerb and not crossing the road. This is known as the OODA loop. Observe, orientate, decide, and act. “Loop” because having acted we go back to observing to see what has changed. In our example the road is now clear so we can reach a decision that it is safe to cross the road so that is what we do.
In many cases, by observing, we do not in fact take any action, as either our experience (orientation) tells us not to or our lack of experience requires us to take further observations and learn from them and from others. Reacting on impulse (emotion) rarely results in the best of outcome for investors.
If opinions don’t help, what does? Data is the answer but there is rather a lot of it, so what in particular?
The key driver of markets; equities, bonds, commodities and currencies is the rate of change of both GDP growth and inflation. Note that rate of change is not the same as the absolute number.
In the case of inflation, it is not going away anytime soon but the rate of change in the monthly number is beginning to slow. Partly this arises as a result of comparing year on year data and partly because with economic growth slowing (US GDP is on course for sub 1% in QI versus 7% in Q4 2022) demand will also slow which will alleviate pressure on prices. A higher oil price will affect inflation, but it too will have a negative effect on global growth given the reliance we still have on fossil fuels.
A slowing rate of change in both growth and inflation is usually a negative factor for equities in general, commodities and credit, especially high yield. We have seen the downdraft in equities so far in Q1, particularly in the US and the slowdown in GDP growth is expected to continue into Q2, especially if the central banks continue with their tightening policies. Commodity prices on a year on yar basis are also slowing with the aforementioned exception of oil. The Federal Reserve is under a lot of pressure from the White House downwards to “do something” about inflation. The propensity “to do something” before “taking more observations” is the key to where monetary policy is going to take us.
One thing experience tells us is that in the long run geopolitical events and market shocks, whether geopolitical or from monetary policy mistakes or other reactions do not last forever. Our personal experience goes back to the bear market of 1973/74. The Dow Jones Industrial index bottomed at 578; today its’s north of 33,000. Another thing from our orientation is that market timing is next to impossible. You may get it right once but that will most likely be put down to luck.
Whilst being 100% in cash from January 1st would have been a good “bet” it just creates another very difficult decision which is when to get back in. We take the view that being in the sectors that will work best towards capital preservation in volatile markets (underweight US, fixed interest in general and building positions in real assets) is the best path to take and when conditions change, particularly with regards to the rate of change of growth and inflation rates, probably in the second half of 2022, we will observe that change, orient, decide and act appropriately.