Bumps in the road ahead and how to prepare for them

It has been a strange couple of years for investors. There was a lot of noise and panic in the air back in early 2020, when stock markets and asset prices plunged in response to the Coronavirus outbreak.

However, an unprecedented speedy recovery meant that investor despair quickly turned into joy. Indeed, many investors who stuck the course during that rocky period may now be happily looking at a portfolio with a higher value than back in March 2020.

With stock markets once again looking expensive – in the US in particular, with the NASDAQ index continuing to hit record highs – and lots of noise about inflation and interest rates, there could be some choppy waters ahead in 2022 and beyond.

To address some of the main investor concerns right now, our Investment Committee asked independent researchers and portfolio managers Morningstar for their views on what to look out for, and how they are preparing for some potential bumps in the road…

Question: What are the biggest downside risks for investors today?

Dan Kemp (Morningstar Global Chief Investment Office): It is a hard truth of investing that the biggest downside risk to the investor is themselves. 

While high inflation, market crashes and pandemics can all create short-term disruptions, the permanent damage tends to occur when we make poor investment decisions. Such decisions tend to occur when we allow our emotions to govern our actions and fall into two main groups:

1. The first is overconfidence and a belief that recent high returns can be replicated in the future. This can lead to investors over-paying for an asset and never achieving a return as the price reverts to a more realistic lower value. The technology ‘boom and bust’ at the turn of the century is probably the best-known recent example of this.
2. The second is driven by fear and occurs when investors sell holdings following a crash. By doing so, they realise losses that would otherwise have been erased in a subsequent recovery. The recent experience of investing through the pandemic is a great example of this situation. 
    

The challenge for investors is that markets are cyclical and so are the emotional pressures. Combatting these emotional pressures requires a strong investment process and the ability to think independently. 

Question: Is China un-investible now they are cracking down? What does that mean for emerging markets exposure?

Mike Coop (Morningstar Chief Investment Officer EMEA): China’s crackdown is a stark reminder that investing is more than just buying low 
and selling high. Ultimately, governments have the power to tax, fine, seize assets, nationalise and imprison. But their power to spend and subsidise also creates opportunities. 

In truth, investors have always lived with this uncertainty, and many will have been burnt by a sudden policy shift at some point in their investing life. This does not make a market un-investible, but it does mean we need to be ready for future shifts in policy. 

The big question is what investors should do in response to the bad news? This is quite a delicate one to answer, as it depends on your starting position, risk tolerance, and objectives. 

Our experience of prior pariahs – where we have made high returns for investors in our multi-asset portfolios – include Russia, Korea and energy equities. The common features of these contrarian opportunities included:

1. Terrible economic or corporate news;
2. Sustained selling;
3. 50% + falls in share prices;
4. Extreme lows in price vs fundamentals, using historic and a range of potential scenarios; and 
5. Alarm, disdain and pessimism from the investing community.
    

From a long-term valuation driven perspective, the China crackdown has some, but not enough, hallmarks to make it a great contrarian opportunity. That said, China now offers better value than before the sell-off, even with allowance for the impact of announcements and potential further shocks. 

Our portfolios reflect this assessment: having had less exposure than usual in China, we have been topping up exposure from low levels in more growth-oriented multi-asset portfolios.

Question: Will we see slower Gross Domestic Product (GDP) growth than what we anticipated six months ago? Do we see a slow rise in interest rates on the horizon or a fast one? Will interest rates stay the same or go down?

Dan Kemp: Both GDP growth and the future direction of interest rates are important in determining the return on your investment. The former is a measure of how much companies can sell, and the latter determines the cost of the capital used to fund them. Knowing the direction of both is a huge advantage for investors, in theory. 

In reality, attempting to predict these variables is rarely a profitable investment strategy. The reason for this is threefold. 

• First, GDP and interest rates are only two components of a far more complicated calculation that determines the profits of a business, or it’s cost of capital. 
• Second, these variables have remained stubbornly resistant to accurate forecasts, with many highly respected professional economic forecasters having track-records that would make an astrologist blush. 
• Third, market prices react almost immediately to new information. 
   

So, how do we address the challenge of unpredictable but significant influences in portfolios? Rather than waste time trying to predict the unknowable and unprofitable, we ensure that our portfolios are robust to a range of potential outcomes. 

Testing the robustness of our portfolios is a key element in our portfolio construction process. To help us, we have developed a tool that enables us to simulate the behaviour of portfolios in a range of economic scenarios. Like the crash tests used to examine the safety of cars, we use this process to identify weaknesses in portfolios so that they can be addressed before we invest clients’ money.

We hope that this article has helped to answer some of those burning questions which you may have had recently. Please do not hesitate to get in touch should you have any questions or concerns regarding your portfolio or wider financial planning needs.  

This article is for information purposes only and the opinions expressed are those of the contributors’ only. The value of investments can go down as well as up.