Volatility is part and parcel of equity investing, and this short-term spike should therefore not be seen as out of the ordinary. If anything, the relatively subdued volatility markets have enjoyed year to date has been the outlier. The real question becomes whether this increased volatility is the start of something more foreboding for markets? 

Over the first three weeks of August, global and local equity market volatility has spiked sharply.

Equities have sold off and safe-haven assets, such as gold and treasury bonds, have outperformed. Investors’ appetite for risk has waned in the face of increasing concerns about the sustainability of global economic growth, fuelled by heightened trade tensions, geopolitical uncertainty and fears that monetary and fiscal stimulus may no longer be enough to sustain growth in the real economy, meaning an increased likelihood of a global slowdown, or even recession.

Volatility is part and parcel of equity investing, and this short-term spike should therefore not be seen as out of the ordinary. If anything, the relatively subdued volatility markets have enjoyed year to date has been the outlier. The real question becomes whether this increased volatility is the start of something more foreboding for markets?

Market concerns…

As we mentioned in previous notes, the Federal Reserve cutting rates and halting its balance sheet reduction programme is in response to a deterioration in the global economic outlook. Fundamental economic data out of the US points to rising input costs and slowing project investment, as the uncertainty around trade has kept business on the sidelines. Consumer spending, which is 70% of US GDP, has held up but that could change if businesses begin to aggressively cut costs to protect margins.

Globally, most developed economies are struggling to generate sufficient internal demand to lift economic growth back to trend levels. Emerging markets have their own set of issues – largely related to excessive borrowing and a lack of fundamental economic reforms over the last decade – and remain very exposed to a slowdown in demand out of developed markets. China is an exception: it is large enough to drive internal consumption growth and the government is committed to supporting the economy via both monetary and fiscal policy levers.

It is against this backdrop that the worsening trade rhetoric must be considered. Contrary to what Mr. Trump has said in the past, we do not think trade wars are good or easy to win. Protectionism has historically been negative for GDP growth, and we expect such measures now would hold true for both the US and China. Given that these two economies are essentially the only marginal drivers of global growth at present, the impact elsewhere would be very negative, and hence the intense risk-off sentiment that has dominated markets.

We do think the Fed will likely be forced to intervene again in providing monetary support to the market, though the impact this could have on the real economy is likely marginal. Instead, we prefer to focus on the business cycle, which is well advanced.

Here are actions I’ve taken

I have taken several steps to address these risks in the fund I run.

Firstly, the cash position has been elevated for some time, and is currently around 10%. Over the last few days, we have been opportunistically deploying cash into businesses where we believe the risk/reward profile is attractive. Given the uncertainty of the outlook, we think that being disciplined on what price we pay is the correct decision, as it is aligned with our fundamental research process and long-term investment horizon.

Secondly, we have reviewed our holdings to ensure we are happy with the quality of the assets we own, particularly from a balance sheet perspective. The portfolio of companies in the fund generate a superior return on invested capital and has substantially less debt than the average business, with most of our holdings having net cash positions on their balance sheets (e.g. Alphabet, which I wrote about last week). The businesses we own tend to generate a substantial amount of free cash flow, meaning they should be able to withstand a slowdown or a downturn in the global economy. Additionally, our businesses are mostly exposed to secular growth drivers, meaning revenues are not solely dependent on economic activity or stimulus. This doesn’t mean our holdings are insulated from an economic shock – merely that they have some internal engine of growth that should see them hold up somewhat better.

Lastly, we have increased the diversification and defensiveness of the fund by increasing our exposure to the health care and consumer staples sectors. In the event of a slowdown, we believe these names present a more compelling risk/reward profile, as well as being aligned with our investment process of looking to own high-quality, cash generative businesses over the long term. Interestingly, Estee Lauder (EL.US), our largest consumer staples weighting, delivered excellent results this week and rally to a fresh all-time high.

This combination of quality and growth comes at a price. However, as the companies in the fund are generally more expensive than the index. Where we believe valuations don’t offer an attractive risk/reward profile, we have already taken action: Netflix was reduced in July (prior to releasing its results), and we also reduced the direct exposure to Chinese names based on the view that the market was pricing in a very benign outcome to the trade issue with no supporting evidence. The direct Chinese exposure of the fund is now around 8% – down from nearly 17% at the end of June 2019.

It is also worth pointing out that companies that exhibit the quality and growth characteristics we look for tend to hold up better when growth concerns increase, as these are the kinds of businesses best positioned to weather a slowdown. However, being the last names investors want to sell, they can be volatile during periods when the market is retreating to safe haven assets. On the plus side, they tend to recover earlier and rally harder, as fundamental investors step in to buy these assets at attractive prices.

And here’s my conclusion…

There is no shortage of market commentators fervently trying to identify the final data point that will end this long bull market. Will it be an unguarded word by a central banker, a disappointing GDP print or the yield curve inversion? What of Brexit – nearly forgotten in the current flood of news – or the prospect of a military mishap in one of several hotspots around the world?

No one knows the answer, but we also think trying to time the downturn is essentially a futile exercise. Instead, we remind ourselves to think long term. In that regard, the temptation to look at daily, weekly or monthly performance is almost a guaranteed way to ensure we trigger the natural loss aversion trait hardwired into the human psyche and make poor investment decisions.

Source: MSCI, Bloomberg, AIM.

The chart above shows the frequency of experiencing a loss when looking at returns from the MSCI World index for the period 31 July 1999 to 31 July 2019.

Clearly, investors who look at daily performance have reason to be concerned – there was a negative return roughly 46% of the time over a 20-year period. An investor limiting themselves to looking only at rolling one-year returns would see a negative number only once every three times, whilst those with even more patience sees the frequency of a loss reduce even further. The truly patient – who only think about returns over a seven-year cycle – would find they only suffered a negative return 2% of the time over a 20-year time horizon – a period that included the global financial crisis of 2008, 9/11, and the second Gulf War.

We believe in paying a reasonable price for growing, cash generative businesses with a sustainable competitive advantage that can compound in value over time. Successful investing is built on identifying such businesses and letting the compounding effect take hold. At present, we think a focus on quality, valuation and adequate diversification will serve investors well over the long term.

Don’t be spooked by short-term equity market volatility. Take advantage of it and increase your exposure to the best businesses in the world.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.