Generating returns in uncertain regimes
4 min read 29 Apr 24
As the last few years have aptly demonstrated, pandemics, wars and wildly fluctuating economic variables such as surging inflation and sweeping interest rate hikes have all contributed to heightened periods of uncertainty and volatility in financial markets, often at the expense of patient and unassuming long-term investors. Stuart Canning, Fund Manager in M&G’s Multi Asset Team, assesses the value of Dynamic Multi-Asset allocation in a world of shifting expectations.
It is a truism that investors are always beset by uncertainty, but the post-pandemic period has brought uncertainty of a specific type: that of assessing the regime.
For the M&G Multi Asset team, the investment ‘regime’ refers to the general environment for long-term dynamics, such as inflation, policy and demographics. In today’s environment, it necessitates asking the following questions:
- ‘Is inflation high and unstable, or anchored?’;
- ‘Is there free trade between nations or are there impediments?’;
- ‘Is the environment supportive for companies to make profits, and return those profits to shareholders, or do incentives or the power of labour put a check on those forces?’
The answers to these questions have important implications for asset allocators. When the regime was one of high and rising inflation in the 1970s both equities and bonds delivered negative real returns (and often with positive short-term correlations). The notion of fixed income assets as safe havens in that period would have seemed a strange one to many.
By contrast, the transition to a low and stable inflation and rate regime led to strong gains from almost all major assets, as well as diversification when required. While it never felt like it at the time, particularly with financial crises and global pandemics, the regime has been very supportive during the working careers of many of today’s investment professionals.
Swaying confidence
Last year demonstrated what happens when confidence in the regime is shaken. Uncertainty over whether we were entering a ‘higher for longer’ regime or not resulted in the biggest US bond market sell-off since the nineteenth century, according to a Bank of America research note1, only for yields to almost entirely reverse course in the last two months of the year.
This volatility can be seen in the chart below. The MOVE index, a measure of bond volatilty, remains highly elevated, at levels comparable to the sell-off from ultra-low yields immediately post-pandemic and the 2008 financial crisis. Focus on regime issues like the US fiscal position, the impact of spending to tackle climate and other issues in October 2023 quickly reverted to the usual guessing game of shorter-term cyclical dynamics ie, how many cuts will the US Federal Reserve (Fed) make in 2024?
What is interesting against this backdrop has been the relative resilience of equity markets, and not just in the US (as illustrated by the Vix) where both delivered earnings and optimism about the future of AI (Artificial Intelligence) have dampened much possibility for price weakness, but also in Europe (as illustrated by the VSTOXX European volatility index).
Rising rates had a huge impact on the valuation of equities in 2022, but only briefly in Q3 2023. This is consistent with a view that, although there has been a lot of talk about regime change which has served to exacerbate the extent of bond volatility, most investors subconsciously feel that we will ultimately return to the ‘low and stable’ regime. This can be seen not only in the apparent stability in equity markets, but also the inverted yield curve in the US, and longer-term ‘breakeven inflation’, which has remained at around 2%.
Does last year’s reversal in bonds and relative stability in equities mean the regime question was a false alarm and is now resolved? Almost certainly not; markets can take many years to acknowledge structural change and shake off old anchors and rules of thumb. Indeed, it took markets a long time to accept that we were in a low inflation world in the decade following the GFC, ushering in a period of stellar returns for fixed income assets.
The ‘fair value’ anchor
Faced with the uncertainty around regimes, volatility emerges because investors lose their sense of an anchor for where ‘fair value’ lies for an asset.
This challenge can create all kinds of mistakes. Human beings are averse to uncertainty and a sense of losing control. However, in many aspects of life, uncertainty can be reduced by collecting data, analysing it, and making predictions.
This is far less true in investment markets where the most meaningful information is available to all, where many outcomes are possible, and where investors seek to pre-empt each other’s actions. It doesn’t just matter what the facts say, but how others will interpret those facts.
As a result, investing is one area of our lives where gathering more information can be dangerous. It runs the risk of believing that we can be more certain than we actually are, and it is this overconfidence that arguably drives a large proportion of the bubbles and crashes that are still a hallmark of investment markets.
The last few years have been a classic example. When we think about the ‘folly of forecasting’ what comes to mind is often events that come out of the blue (‘exogenous’ shocks) – the Covid pandemic being a standout example. However, the dangers of forecasting also apply even when we don’t have the excuse of an external shock. The failure of widespread and confident predictions of a recession in the US economy to materialise last year is well-known. With hindsight, experts may talk of US government spending or excess savings as holding off the recession, but ultimately the failure is not one of a lack of information, but overconfidence.
Moreover, as we constantly emphasise, even if one’s forecasts are correct, it doesn’t mean asset prices will respond as one might expect. A host of economic contractions took place in 2023: Germany entered a recession early in the year, while the UK and Japan experienced these later in the year. However, this didn’t stop the Japanese and German equity markets being among the strongest in the calendar year. Most bond markets also did well, though not because of the anticipated recession, but due to easing inflation pressures and attractive starting yields.
"Faced with the uncertainty around regimes, volatility emerges because investors lose their sense of an anchor for where ‘fair value’ lies for an asset."
Dealing with uncertainty
Most sensible investors are very aware of the dangers of forecasting macro-economic fundamentals and the market gyrations that accompany them. This is why, despite the temptations to do otherwise, most believe in investing for the long-term and reducing the risks of having all your eggs in a single basket.
This forms the rationale for passive multi-asset investing. However, as the 1970s demonstrated, positive returns over significant time periods are not guaranteed, nor is the type of diversification across asset classes that people have become accustomed to in recent decades. Indeed, when the United States makes up 70% of the MSCI World, and the top ten stocks (all US) make up 20%, the passive option need not be the option that most spreads risk2.
Most importantly though, while passive ‘set and forget’ asset allocations are almost certainly superior to trying to time every twist and turn of the market, they can be indifferent to the starting point of value, holding the same equity weight during the tech bubble as in 2009, or holding the same amount of bonds yielding 4% as they did when yields were zero.
The ‘Episode’ approach
The M&G Multi Asset team do believe there is a role for active asset allocation, and that significant flexibility is an important part of this.
Importantly their view is that markets do display periodic episodes of inefficiency, often driven by the short-term time horizons and emotional motivations of investors. That these emotional influences are no less evident in apparent experts is evident in the experiences of the last few years and the periodic booms and busts in asset prices. Nor does the rise of quantitative strategies seem to have driven greater market efficiency at a macro level; indeed, the rise of short-term trend following and the use of similar risk models and stop losses can arguably exacerbate excess short-term volatility.
This offers benefits to investors, who do not have to make a correct forecast of the future regime here and now, but rather, can watch the facts as they emerge and wait for the market to either deny them because they are anchored to the old regime, or ignore them because whatever is grabbing the headline that month is so much more salient. One didn’t need to predict a coming regime of low and stable inflation in 1981, it was enough to see that that there had already been a decade of lower rates by the late 1990s, and then be sceptical every time the market feared ‘a return to the 1970s’ or the impacts of ‘excessive money printing’ after the GFC.
Even better, with a clear framework it may be possible to enhance returns and reduce risk by taking advantage of the opportunities provided when markets swing from one overconfident view to the next – and compensate well for taking the other side. Responding to these short-term ‘episodes’ in markets has been a key part of the teams’ approach for over two decades and were particularly valuable in Covid and its aftermath. More fears of regime change, and particularly a regime change itself, could create the type of volatility that is a positive for that type of approach.
1Business Insider, ‘The rout in US Treasurys is now the worst bond bear market of all time’, (markets.businessinsider.com), 9 October 2023.
2MSCI, ‘MSCI World Index (USD)’, (MSCI.com), 31 January 2024.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.
