Uncertainty levels are high currently
Uncertainty is at the heart of the stock market slump of recent weeks as investors face difficult questions – when, how fast and by how much will interest rates need to rise in the US? When will inflation ease? What are the consequences of Russia invading Ukraine? We see this uncertainty in our asset allocation dashboard (Chart 1). Sentiment is fearful and momentum has drained away despite positive indicators for valuation and macroeconomic fundamentals such as earnings, economic growth and employment.
Uncertainty differs from risk. Risks can be reduced to probabilities and quantified. The chances of living to a certain age can be calculated actuarially. Once estimated, the risk can be priced. The insurance industry is built upon the principle that it is possible to insure against the occurrence of a specific event.
Uncertainty cannot be priced. It is unquantifiable.
No one knows the outcome until the outcome presents itself which is why markets have only in the past few days reacted to the conflict in Ukraine. There was even a relief rally once the invasion began. This goes to the heart of the maxim: “Buy to the sound of cannons, sell to the sound of trumpets”. The sound of cannons signals the end of some of the uncertainty.
Not all the uncertainty has been resolved, however. Will NATO be dragged into a broader war? Are we on the cusp of a multipolar world and what would that mean for risk premiums? Questions around monetary policy and inflation remain as uncertain as ever (indeed more so now). How should you invest when visibility is so poor?
Chart 1: Escala Partners CIO Asset Allocation Scorecard
Mentions of the word “uncertain” by the RBA at a peak
The level of uncertainty we are operating in currently feels very high and if the minutes from the Reserve Bank of Australia (RBA) monthly meeting are anything to go by we would be right. The chart below shows the number of mentions of the word “uncertain” in the monthly meeting minutes going back 12 years. Some of the peaks are worth pointing out:
1) June 2018: Political risk in Italy rose when President Sergio Mattarella blocked the formation of a government that would have been decidedly against the euro. The move raised the breakup risk of the euro.
2) May 2019: Trade tensions between the US and China posed a risk to the global growth outlook. At the same time, low income growth domestically posed a risk to the outlook for consumption in Australia and hence economic growth.
3) March 2020: Actions taken by the Chinese authorities to limit the spread of COVID-19 severely restricted economic activity in China in the March 2020 quarter.
4) August 2020: The lengthening and tightening of restrictions in Melbourne, and the extension of restrictions to regional Victoria created uncertainty around how it would affect economic activity in the whole of Australia.
5) November 2021: Uncertainty around the labour market response in terms of the supply of workers and the impact on wages.
Chart 2: Reserve Bank meeting minutes mentions of the word “uncertainty”
Monetary policy to be “flexible” given the uncertainty
The RBA acknowledges we are in a period of particularly high uncertainty. This makes forecasting economic outcomes very difficult and therefore requires the operation of monetary policy to be “flexible”.
The current crisis in Russia adds to this uncertainty for policy makers. Do central banks raise interest rates because higher oil prices add to inflation pressure or do they delay rate hikes because of the impact higher energy prices will have on household budgets? Indeed, do they offer fiscal assistance packages as is the case in Italy?
Uncertainty is a fact of life for investors
The reality is that uncertainty is a fact of life for investors. It is always and everywhere a present feature lurking in the background. It is just that sometimes it moves to the foreground.
The chart below is a reminder of how uncertainty is a part of investing. Through each decade investors have been confronted with considerable uncertainty. Wars, terror attacks, political upheavals, pandemics, economic and financial collapses are part of the investing landscape.
We can see how this uncertainty has affected equity markets through time. The two charts below show the performance of the US S&P500 Index as well as the maximum drawdowns.
None of the many conflicts that marred the past five decades caused a bear market.
Not the Iran/Iraq War. Not the first or second US wars in Iraq. Not the Balkan War. Not Israel’s conflict with Hezbollah. Not the Syrian Civil War. Not the US involvement in Libya or Afghanistan. And not Russia’s invasion and annexation of Crimea. In most of these instances, equities did decline as tensions escalated, but they began bouncing back shortly after fighting broke out. Not because armed combat is bullish, but because the fighting ended some of the uncertainty.
Chart 3: US S&P500 – Level and drawdown (2010-2022 and 1970-2010)
What is interesting to note from the above chart is that in the past 12 years (2010-2022) we have had as many episodes causing major market drawdowns as we did in the 40 years prior (1970-2010). The difference is the average drawdown in the last dozen years is significantly less than what we saw previously.
The average major drawdown in the 1970-2010 period was 35.8%. In the 2010-22 period it was half that at 16.1%.
This can partly be explained by the actions of the US Federal Reserve. Since 2010, the US Federal Reserve has expanded its balance sheet by $US6.6 trillion taking it to almost $US9 trillion, more than quadrupling its size. Prior to 2010 the expansion of the balance was relatively minor in comparison.
Chart 4: US Federal Reserve Balance Sheet ($US trillion)
Risk can be priced, uncertainty can’t – scenario analysis helps
Risk is randomness in which events have measurable probabilities, wrote economist Frank Knight in 1921. Risk, in other words, is quantifiable. Uncertainty, isn’t. So how should investors navigate an uncertain environment?
One approach we like, and which has been adopted by the Reserve Bank currently, is scenario analysis.
For us, our base case scenario is that growth will ease from here taking the sting out of inflation. The US rate hike cycle will be sensitive to financial market indicators of recession risk. Bond yields will stabilise but remain at low levels in-line with lower inflation and growth biased assets will reassert themselves.
Our alternative scenario is inflation remains sticky and the Federal Reserve is forced to raise rates aggressively sending the economy into a recession. Higher energy prices in Europe leads to a recession there. We would call this the “what if we are wrong scenario”.
We have constructed our portfolios to accommodate this alternative scenario. We have reduced our exposure to growth-biased funds, increased our exposure to inflation hedging funds such as infrastructure and other real assets. We are keeping our exposure to government bonds low and our exposure to floating rate credit high.
With visibility so poor we are keeping our tactical positions to a minimum, reserving our budget to only high conviction ideas such as our overweight to alternative assets.
The most important thing any investor can do in times of uncertainty is to have a process and be disciplined in keeping to it. It is also important to understand what you know and what you don’t. When the later outweighs the former, good investors patiently sit on their hands and trust their strategic asset allocations.