Market news and our thoughts on building better portfolios.
Market News
Big misses on both US consumer confidence and job openings prompted speculation the Fed is nearing the end of its tightening campaign. The Conference Board Consumer Confidence for August came in at 106 vs 116 expected, while US JOLTS job openings for July were 8.8m vs. 9.5m expected. The 10-year Treasury yield fell from 4.24% to 4.14%. The dollar fell and gold rose and currently trades at $1,935 an ounce.
US equity markets jumped in response, led higher by mega-cap tech names: S&P 500 (+1.5%); Nasdaq (+1.7%). This morning in Asia, markets were mixed, with chip stocks leading the way: Nikkei 225 (+0.3%); Hang Seng (-0.2%); Shanghai Composite (+0.04%). The FTSE 100 is currently trading 0.5% higher at 7,504.
Chinese state-owned lenders will cut mortgage rates, while China’s biggest stocks ETF is poised to see its biggest monthly inflow on record.
UK home sales are on track to drop to the lowest in over a decade as high mortgage rates grip the housing market. Residential transactions in 2023 are set to fall over 20% from the previous year, according to Zoopla. Deals involving a mortgage are expected to drop 28%. In another sign of weakness, buyer demand declined by more than a third in the four weeks to 20 August compared with the average for the same period over the last five years. Sterling currently trades at $1.2631 and €1.1626.
Brent Crude advanced to $85.30 a barrel on signs of another substantial draw in US inventories. European car sales jumped by 17%.
Source: Bloomberg
Investment View – Building Better Portfolios
The past 18 months have proved challenging for investors of all stripes. Until recently, the entire experience of even the most seasoned investors was built exclusively in a period of secular disinflation. For most people this meant some version of a balanced portfolio of equities and bonds did a decent job of preserving and growing the real value of their wealth. Indeed, the entire industry is built around this framework, with the ratio between the key asset classes determined by an assessment of the desired level of risk. The less risk, the higher the bond allocation.
The issue today is that there is significantly more uncertainty ahead. There could be a deflationary collapse, global war, monetary inflation or more hopefully, something in between. When constructing a portfolio, we need to be able to create a tolerable outcome in a whole range of scenarios because we genuinely cannot know what will transpire. The future path of events is, to use a ten-dollar word, stochastic. It depends on actions and choices we can’t even frame today, let alone predict the implications.
Is there anything we can do to improve the basic portfolio construction to improve our risk-adjusted returns and leave us better placed to prosper financially whatever the future holds? Let’s have a go.
First, let’s lay down some basic assumptions. Firstly, over long periods of time, holding financial assets gives a better return than holding cash. This is particularly obvious in respect of physical banknotes which get eroded over time by inflation but is also true of instant access cash deposits which tend to attract poor interest rates. There are times when very short-term cash or cash-like instruments do well, but this tends to be during periods of tightening monetary policy like we have seen in recent times.
Secondly, the fundamental premise that within financial assets, bonds are less risky than stocks, is sound when we think in nominal terms. However, this may not be the case over long periods when inflation is the most likely threat to the real value of the portfolio. The problem for most investors is that neither equities nor bonds tend to do well during structural inflation.
When considering building a portfolio that is likely to be robust under different economic conditions, we need to add assets that can do well during periods of inflation. These include commodities, gold, and inflation-linked bonds. Note we are not making a forecast that inflation will remain elevated on a structural basis. We are simply saying that a portfolio that includes these assets is better balanced to the different potential inflation regimes.
Everything mentioned so far relates to different assets that one can own, each with some level of expected return over time. The final category to consider is return streams derived from manager skill (or alpha as it is known in the industry). The returns from owning assets can be considered as quite reliable over long periods but depending on the exact asset in question, quite unreliable over short periods. Generating alpha is difficult, often transient, and expensive to access. Nevertheless, if allocated to thoughtfully, it can contribute a diversified, uncorrelated source of returns that improves portfolio risk-adjusted returns. Commodity trend-following strategies, for example, offer the potential to capture some of the major moves that can occur in this asset class but without committing to the long-term low returns of a buy and hold approach.
The key to portfolio construction is not optimising around what you think you know about the future, but about understanding that you need a portfolio that can deliver across the diverse range of outcomes that are possible in today’s uncertain world.