investment insights
Weathering economic turmoil: keep calm and stay invested
Lombard Odier Private Bank
There is a mounting sense of nervousness in financial markets. Some of it is certainly justified and reflects the desperate plight of Ukrainians, as well as concrete concerns on many other fronts: increased uncertainty amid monetary policy normalisation, and persistently high inflation figures on the back of supply chain disruptions linked to the Covid resurgence in China, to name the most preoccupying ones. Yet, while the macroeconomic picture may not be rosy, I personally don’t view it as acutely alarming either, with plenty of reasons to stay invested, albeit with increased caution.
While the macroeconomic outlook has indeed deteriorated, the media tends to aggravate the situation to maximise their audience. Far from treating information with objectivity, the human brain is considerably more responsive to negative than positive news. Researchers believe this is a deep-rooted evolutionary relic from back when numerous existential threats, like the presence of a nearby predator for example, called for particularly fast reactions. From a species survival standpoint, it makes sense that our ancestors would react quicker to the company of a preying cheetah than to the sight of an apple in a tree. Our resulting “negativity bias” means that we are more prone to read, react to, and recall traumatic experiences than pleasant ones. In summary, as University of California at Berkeley psychologist Rick Hanson puts it: “The mind is like Velcro for negative experiences and Teflon for positive ones.”
This inherent cognitive bias can influence journalists to write negative articles, which can up their following and advance their career. A popular motto in newsrooms is “if it bleeds, it leads.” A Dartmouth College and Brown University study conducted in 2021 outlined that US media are particularly prone to what the New York Times coined as the “bad news bias.” Looking into Covid-related publications, the paper shows that almost 90% of all pandemic-related articles in national US media were negative, as opposed to 50% and 60% in international and scientific media, respectively.
The negativity bias has important implications in several other areas including politics. For example, research has shown that candidates are more likely to earn votes by warning against the (real or fabricated) flaws of their adversary, rather than by putting forward their own capabilities. Most recently, Emmanuel Macron seems to have perfectly executed on this strategy in the French presidential election, securing a win despite weak popularity figures by framing himself as a rampart against a reportedly dangerous Marine Le Pen.
Another area where our negative penchant is targeted is of course financial news, with inflation seemingly being the spearhead in the last few weeks. Having started my career exactly 30 years ago as a fixed income portfolio manager in Paris, as you would expect, I get a sense of déjà vu every once in a while. That said, this sentiment has seldom been as stark as today, with headlines taking me back to my first year on the job. Back in 1992, inflation was strong throughout Europe, with year-on-year figures at 7.1% in Spain, 5.1% in Germany, 5.0% in Italy, 4.2% in the United Kingdom and 2.5% in France. Meanwhile, Federal Reserve Chairman Paul Volker’s work in the US was just starting to bear fruit, with inflation coming down to 3.0% in 1992, from 4.2% in 1991 and 5.4% in 1990. These high single-digit figures were of course challenging, but certainly manageable. I would argue that if we were able to rub along then, we should certainly be able to now, as we continue to benefit from a robust post-Covid growth rebound, strong employment figures and more experience in terms of what works and what doesn’t from a central banking perspective.
To be clear, I am by no means claiming that inflation is not an issue or that it is bound to recede. If you put together our unprecedented recourse to money printing for more than a decade, pandemic-induced blockages of global trade channels, and geopolitically-driven disruptions in energy and commodities supplies, inflation reverting to central bank targets doesn’t seem likely in the foreseeable future. This said, in contrast to what some alarmist headlines suggest, we still see opportunities in the market and are staying invested.
To help navigate the current high-inflation environment, we have built a matrix outlining examples of possible portfolio tilts to adopt depending on US growth and inflation assumptions over the next year (see below)1.
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Our base case scenario for this year is a prolonged and potentially escalating conflict in Ukraine, slowing yet healthy global growth of around 3.5%, and decelerating yet above-target headline inflation of around 6.5% by end-year. Against this challenging backdrop, as highlighted in the table, we have an overweight to a broad basket of commodities including oil. We remain overall neutral in our equity positioning with increased differentiation within the asset class. We have recently raised our US stock exposure, given the market’s more defensive characteristics. Concurrently, we have reduced our exposure to small capitalisation stocks to underweight, while maintaining our preference for UK, value and quality stocks, and the energy and healthcare sectors. We are underweight on the fixed income front, with the exception of emerging market debt, where we find attractive carry in Brazil. In addition to these positions, we retain our overweight to the US dollar as well as an allocation to European real estate. We have also expanded our cash buffer to give us the capability to seize opportunities as they arise. Lastly, we have taken advantage of the elevated volatility level and skew to add downside shielding to equity positions through options strategies.
We are of course monitoring the US fixed income markets very closely and are starting to see attractive risk-free returns as yields rise sharply. US Treasuries may be all the more attractive considering increased uncertainty within other financial assets. On a more personal note, after spending 30 years trying to convince clients to divest away from liquid fixed income, I may ironically now engage in persuading them to invest back into the asset class.
1Source: Lombard Odier
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