The first half of the year was the worst for financial markets in more than half a century. It had been a long time since stocks and bonds behaved so poorly at the same time. Furthermore, with rising interest rates and high inflation, earning positive real returns has become almost impossible. The central part of the summer has been an oasis. Rather the mirage of an oasis. With the stock markets recovering a good part of the losses. But what lies ahead for the latter part of the year is more than challenging. And managers and bankers increasingly find fewer options where to seek shelter for their clients’ money.
Jeremy Grantham is a famous British investor, 83 years old. In a note to clients of his manager GMO, he explained on Wednesday that “we are still in a superbubble in which real estate, stock and bond assets remain highly overvalued.” In his opinion, the bear market is only in its first phase, and the summer recovery (which is now ending) is only the prologue for much higher corrections.
The only argument that has served to justify the rise in the stock markets in July is that it seemed that the central banks were capable of containing inflation. However, the data does not fully support this thesis, and the message of the Fed president, Jerome Powell, in Jackson Hole, wanted to underline that the world must prepare for a prolonged period of high interest rates.
Michael Strobaek, global investment director of the Swiss bank Credit Suisse, recalls that we are going to have to face an environment of “slowdown economic growth, including recession, high levels of inflation and rate hikes.” This, combined with a war in the heart of Europe and cuts in the supply of gas and oil, which can cause distortions in production chains.
Given this scenario, what can a small investor do with his money? Are there any assets that present better prospects? How to protect yourself in the face of so much uncertainty?
1. Less portfolio risk
More and more investment houses are joining the chorus calling for a reduction in risk in investors’ portfolios. One of the first was the giant BlackRock, which already in mid-July recommended that its clients moderate their exposure on the stock market.
Risk reduction can be achieved by lowering the weight of equities versus bonds. For example, a balanced investor, who had 60% stock and 40% bonds, can turn those percentages around. Another way is allocating a greater part of the portfolio to cash. In the world of mutual funds, cash is equated with very short-term debt or money market funds, which present minimal depreciation risk.
Even within the same asset, risk can be reduced. In the fixed income part, betting more on sovereign debt funds or companies with the highest credit rating, and leaving aside funds with issuers with a worse profile.
All in all, “underweighting the stock market does not mean getting out of the equity markets completely”, Strobaek points out. “It would be bad advice to sell the entire stock market portfolio. With inflation approaching 8% in many countries, having a lot of cash can end up with a guaranteed loss of purchasing power.”
Trying to predict what the market is going to do can be very tempting. If I firmly believe that the Stock Market is going to be bad for the rest of 2022, why not sell everything? The downside is that academic studies have shown, time and time again, that getting ahead of the markets, going in and out arbitrarily, often doesn’t pay off. Not even professional managers.
Duncan Lamont, head of research and analysis at Schroders, recalls that “getting out of the market and taking refuge in cash after a big drop has been negative for the portfolio’s return in the long term.” For example, investors who switched to cash in 2001, after the 25% crash in the dot-com crash, may find that their portfolio still hasn’t fully recovered from its losses to this day.
From Credit Suisse they also affect the importance of diversification at a time like the present. The banking sector has done very poorly on the stock market in the last decade, but could benefit from rate hikes. Technological companies have been the great engine of Wall Street, but now they have collapsed, leaving their place to mining and oil companies that were forgotten. China used to be the locomotive of the world economy, but it has been generating doubts for several years due to its indebtedness and the fatigue of some public policies… Better a portfolio with broad positions in sectors and economies than a very specific bet.
2. Cost control
When a market is in bull mode, costs seem to take a backseat. If a stock market fund in the United States is renting at a rate of 18% per year, what difference does it make if it charges 1% per year or 1.5%? If a conservative fund rises 4% in the year, what difference is there between a commission of 0.5% or 0.8%?
However, when the curves come, it is a good time to take a good look at whether the commissions that are being paid to fund managers or to the entity with which you have a discretionary portfolio management contract are within market parameters. .
Fund fees have been falling for years. For a decade, low-cost funds that replicate the evolution of stock or bond indices have appeared in Europe, and somewhat in Spain. These products, which can be both index investment funds and exchange-traded funds (ETFs), have made it possible to significantly lower commissions, because they do not have to bear the costs of analysis or personnel expenses. In addition, they have shown that the results obtained are usually better than those of most active funds.
Today, paying 2.5% or 1.5% in a US stock fund for another that replicates the evolution of the Nasdaq is not very justified. Same as paying more than 1% for a fixed income fund.
3. Flexible backgrounds
The rise of so-called passive management, with the aforementioned index funds, has meant very strong competition for active managers. That does not mean that everyone has given up. There is still a lot of talent in the investment industry, but you have to spend time finding it.
In the current market context, one of the dogmas that analysis houses repeat the most is flexibility. With such a volatile situation, in which a small failure in monetary policy or an unexpected advance in the war in Ukraine can completely change the landscape, the best thing in the world of active management is to be invested in a fund that does not have a corseted mandate, which can go looking for different investment opportunities.
This is the case of one of the most famous Spanish investors, Luis Bononato, who has achieved a return of 55% so far in 2022. And he has an average annual return of 18% in the last decade, which makes him one of the best in the world.
4. Bonds linked to inflation
Fighting inflation is not easy. Neither for governments and central bankers, nor for small investors. Fixed income funds have been showing dire returns for several months. One of the strategies that have worked best is investing in inflation-linked bonds. As prices go up, the coupon they offer increases. The big problem is that they have become so attractive that they become highly overvalued, so when inflation eases they can suffer significant corrections.
5. Real assets
Another of the formulas that fund managers are testing to try to hedge against price increases is to buy real assets, whose valuation does not depend so much on prices. For example, there are more and more infrastructure funds. These products invest in companies that are dedicated to managing highways, or telephone towers, or that own land where there may be oil or mining prospecting… In all these cases, the companies have a strong capacity to be able to transfer the price increases. Therefore, the value of the assets is adjusted in a smooth way to the advance of inflation.
6. Quality companies
At a time of widespread increases in financing costs and a slowdown in economic activity, a company’s healthy balance sheet becomes essential. The managers take out the magnifying glass to see the degree of leverage. They check if the loans are referenced to variable rates or if they are at a fixed rate. They look at liquidity buffers… But they also analyze market positioning: if it operates in a sector with barriers to entry; if you have a technology or a brand that is difficult to match by your competitors…
A good example is the Dutch company ASML, a world leader in the manufacture of the machinery necessary to produce microchips. The demand for these products is growing, both in home electronics and in smart cars or in industry. There are many semiconductor manufacturers, but only a handful dedicated to the machines that make the chips. Francisco Ruiz, co-manager of the EDM Strategy fund, recalls that it is a company of the highest quality: “it has very clear competitive advantages, it operates in an expanding market and it is capable of financing its growth with its own resources”.
The luxury sector, with groups such as the French LVMH and Kering or the Swiss Richemont, which control some of the most powerful brands of champagne, clothing or perfumes, also continue to be a good refuge in troubled times.
The inflow of illiquid assets
Private banks are clear: if investors want to have a little more profitability and de-correlate from listed markets, they should allocate part of their portfolios to illiquid products. Venture capital funds (which invest in unlisted companies), private debt funds, impact funds and those dedicated to start-ups are growing strongly. They entail not being able to dispose of the money for a period of seven to nine years. But the profitability obtained usually compensates.
Until now, this type of investment was reserved for clients with high net worth, since the minimum investment usually exceeds 100,000 euros. But more and more entities are looking for formulas to bring them closer to all types of clients.
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