Bear markets bring out all the doomsters warning of apocalypse, keen to latch onto a trend and add to the climate of fear. Emotion runs high and it is tough for investors to keep cool. But when stockmarkets are already distressed and cash levels are well above average, is there value in further panic?
Surprises worry; few predicted the problem in liability driven investing (LDI). But the problem looks solvable, particularly in a world of higher gilt yields and likely moderate inflation. The contagion is not obvious, although pension funds may retrench from higher risk areas such as private equity. And the European investment banks that are attracting comment do not look systemic either. Despite alarm at gating of some property funds, this is hardly a new phenomenon. The liquidity mismatch between real estate assets and investor expectations on dealing in those funds is well known and still lacks a workable solution. Any prolonged bull market drives greed and excess in pockets of the economy, but pundits and their sound bites are not making a good case for widespread systemic meltdown.
Stockmarket challenges over the next few months look more predictable. European equities have yet to break out of their downtrend and we can expect a few months more of downward earnings revisions. But economies will turn before the low point in earnings, and stockmarket investors may typically sense green shoots even earlier. When sentiment turns, the tightening of stockmarket liquidity that has crashed many small and mid cap shares can work in reverse to squeeze prices sharply up. Few ever get market timing right, but macro bets may matter less than fundamental company analysis.
Policy errors and contagion are certainly possible, but not a sound basis for investment strategies. If correlations across assets increase, diversification benefits evaporate. And correlation is harder to predict, as it is typically driven by overlapping ownership and illiquidity in some assets. Liquid listed equities might, for example need to take-up some of the strain on portfolios arising from private equity, property, infrastructure and LDI. But, stockmarkets have coped for much of this year with these pressures and at some point everyone has enough cash. It is not as if there are attractive real returns in cash to justify hoarding.
The biggest policy error for the UK might be unnecessary austerity; it is far from clear why the Bank of England should further tighten a rapidly cooling UK economy. Cuts in public expenditure will be hard to find and will likely have negative unforeseen consequences. Bond traders might easily challenge economic policy, but they do not need to get elected. Political expediency makes it more likely the UK will pivot to more of a growth policy, whoever is in power.
One area with embedded leverage that could crash further is private equity, although it does not look systemic. There are now fewer ready exits via IPOs or SPACs: corporate buyers dominate in Europe, but are selective. The business model of borrowing to invest and buy customers is under pressure, and returns will moderate even in the better private companies. But apart from overlapping ownership with some IPOs of recent years and stocks such as Tesla, a private equity sell off might get little attention.
At the moment, there is little that can be done to counter the echo-chamber of gloom, mainly fuelled by those who are not managing money. Assets are repricing after a long boom. But parts of the US, European and UK equity markets have hit valuations that have historically proved a floor. What is missing is confidence in earnings, which may take a few months. Investment strategy should be built on analysis and patience, not emotion.
A version of this article was published in Citywire on 24.10.2022.
