Guard against complacency

Towards the end of the market cycle there is little reward for risk. Whilst this is true today, the current cycle is somewhat different to most. Government bond yields and cash rates are lower than they have ever been, while equity valuations are elevated and credit spreads are tight. All hopes are placed on the fact that the Fed can extend this cycle because if it can’t then there is little conventional monetary policy ammunition left to fight an economic recession, and low cash rates disincentivises investors from seeking shelter. A conundrum created by ultra-easy monetary policy.

There’s a joke about a lost Englishman asking a local Irishman how to get to Dublin. His response was, “Well I wouldn’t be starting from here.” The same could be said for the starting point for markets.

The key to successful investing over the longer term is to remember that future returns are primarily driven by the price you pay for an investment. As it stands today, we should prepare for much lower (and more volatile) returns than we’ve enjoyed in the past ten years. That has profound implications for people’s ability to retire when they want, and the type of lifestyle they will be able to afford.

A prudent approach is to adopt comprehensive portfolio risk management strategies in the forms of genuine diversification, hunting for value, avoiding over indebted companies, and buying portfolio protection (e.g. put options). “Value” and “volatility” are perhaps the two most unloved asset classes, and both of which are likely to help build portfolios resilient to a range of different outcomes (e.g. a recession, or stronger growth with higher rates) and not simply ones which succeed when equity markets go up.

In addition, having cash or term deposits in portfolios means that you will not earn much, but it does give you flexibility which could enable you to buy equities at the time when others are forced to sell. This flexibility can be very valuable to long term returns provided you can act at the right time.

Great companies will continue to prosper irrespective of the economic environment. It is well worth the effort trying to find these businesses while being disciplined about not over-paying for growth which is yet to come. Today’s disruptors are not immune from being disrupted – and while cash rates are so low, there is plenty of money chasing “the next big idea”.

The next decade will be shaped by many factors including how policy makers respond to the next economic downturn. Will it lead to ever more debt and kicking the can down the road? Will it lead to a debt write off and potentially spark inflation, or will there be structural reforms which can drive productivity higher?

We are likely to see a mix of policy responses and shouldn’t underestimate how creative and determined policy makers are. That said, we should not outsource portfolio risk management to “the Fed”.

The one thing we should all do is guard against complacency. 

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This wire is part of the ‘One thing investors can’t ignore in 2020’ series. To download the full ebook please click here.