Ready for the next surprise? Tactical tilts to tackle the unknown

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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. The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.

In a world full of surprises, how investors react to market volatility, economic shocks and geopolitical curveballs can be a critical differentiator of performance. We believe staying   level-headed, flexible and focused on absolute returns enables the required tactical approach.

Today’s complex and dynamic world demands a clear and rational asset allocation framework that also offers the flexibility to adjust quickly to different scenarios in our view.

Achieving that goal is easier said than done. Markets are a manifestation of human emotion and are prone to surprises. In response, we think that using an investment lens that offers such clarity has proven effective over time in dealing with human emotions – and, typically, errors – in managing portfolios¹.  

“A tactical approach coupled with an absolute return objective are highly relevant in today’s environment,” said Stuart Canning, a fund manager at M&G, and head of research for the firm’s macro and multi-asset investment team.

A so-called ‘episodic’ way of investing targets returns in different, often surprising market conditions, and throughout economic cycles, via two key pillars: 

In combination, this agility can offer the possibility of both long and short exposure to a wide range of assets globally, based on market-level analysis to offer diversity. “We thrive using this strategy when markets are more volatile,” explained Gautam Samarth, a fund manager at M&G.

Investing without emotion

Making contrarian decisions that go against human behaviours and bias requires a different mindset in our view. 

Yet having emotional resilience and using it to inform allocations could enable investors to exploit challenging events and markets where behaviourally driven rather than fundamentally driven ‘episodes’ can lead to human overreaction. 

“We look to be contrary and try to do that with valuations on our side,” said Samarth. “It’s a philosophy that looks to identify states of emotional exuberance or panic in the market.”

From trade wars to the pandemic to actual wars in Ukraine and Gaza, market reactions are often extreme. In turn, this response tends to create significant bouts of volatility despite many lessons that have shown the importance of looking beyond temporary shocks. However, knowing these patterns should enable investors to identify the facts but block out the noise that comes from so much opinion and rumour. As a result, investment decisions can be taken without the emotional response that gets shaped by an investor’s own experiences, beliefs and memories.

A case in point is the interest rate shock that started in 2022, and marked one of the most profound shifts in markets in recent years in our view. 

Yet the facts at the time were quite clear. Inflation had already been trending upwards, with the US Consumer Price Index up to around 7% by the end of 2021, while consensus forecasts in early 2022 for average inflation for 2023 were around 2.6%¹.  

General hopes that inflation would moderate during 2022 and return to its long-term average by 2023 were simply ignoring the facts. This optimistic view reflected opinions of people who were overlooking the various components of inflation, and instead pointing to supply chain disruptions as justification for inflation only being transitory. At the same time, central banks were indicating that rate hikes weren’t likely until 2024, around two years later. Further, judgment at that point was made based on an anchored inflation level of around 2% as the long-term average.

“The popular opinion was, there were not going to be any interest rate hikes because inflation was transitory in nature,” said Samarth.

Ultimately, as inflation spiked in the US and around the world, everyone got a surprise of 400 basis points or more in rate increases, as the US Federal Reserve (Fed) acted quickly and aggressively, and many other central banks followed.

Making tactical responses pay 

Monumental surprises cause big shifts in asset valuations, highlighted by the impact on both bonds and equities throughout 2022.

China has been an interesting  case over the past 18 months, with its equity market being relatively "cheap". Yet the time to buy, explained Samarth, was during the 20th National Congress in October 2022, when many market players were worried and daily falls were common. "We acted contrary to that, and captured a significant amount of the returns in late 2022. By the end of January 2023, we had reduced our China position while many investors had made the market their biggest conviction idea for 2023."

Being prepared for such events and insulating portfolios from the impact requires having some barriers in place. “Investors need a framework that can deal with the consequences and reminds them that they will be surprised, and need to turn the disadvantage of human emotion into an advantage,” explained Samarth.

This demands discipline, along with a process of identifying and exploiting periods when certain market episodes lead to emotional responses and mispricings.

“Valuations are probably the best guide in public markets and in asset allocation as to what to expect over the longer term,” said Canning. “This means being disciplined enough to never go long with an asset we think is fundamentally expensive, or short an asset we think is fundamentally cheap.”

A disciplined focus on valuations can help avoid chasing rapidly rising markets and overpaying for investments where a high degree of earnings delivery is required to support prices. For example, markets such as India or the “Magnificent 7” stocks² screen as prohibitively expensive for the Episode approach. 

In parallel, to avoid being caught by value traps from waiting for valuation signals, being nimble is essential to drive tactical allocation decisions during periods of excess volatility or inconsistent price moves. 

A blend of the right valuation indicators and rapid price action that suggests ill-considered behaviour triggers a three-stage process, rooted in key questions:

“All these forces prompt us to be contrarian in nature around these episodes, which we believe give us opportunity when we have valuation on our side,” explained Canning.

The return on 30-year Treasuries in 2023 is a good example of the benefits of this approach. As the market flip-flopped from a strong faith in a Goldilocks scenario³ at the start of 2023, to an intensifying episode of concern about a higher-for-longer regime a few months later, and then debate again about whether there would be four or five Fed rate cuts in 2024, it offered scope to act on the swings in sentiment as an opportunity to be tactical.

No crystal ball needed

We believe being flexible in asset allocation has resulted in notable benefits amid widespread market fears and dislocations over recent years and many other surprise events before then.

In our view the upside in 2022 and 2023, for example, didn’t come from predicting a new regime. Instead, keeping a close watch on the short-term noise around the Fed’s response to rising inflation, and then watching how the market grapples with these issues and observing excess volatility. 

We believe that   approach provided a source of value as a result of being willing to act in a contrarian way. 

^1. Source: Bloomberg, 31 December 2023.
^2. “Magnificent 7” stocks mean Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.
^3. Goldilocks scenario describes an ideal state for an economy whereby the economy is not expanding or contracting by too much. 

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. The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser.

The content of this page reflects M&G’s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. All information included in this page has been written for informational and educational purposes only and does not constitute an offer or solicitation to invest into any security, strategy or investment product. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents.