Ray Dalio runs the worlds largest hedge fund – the Alpha Fund with more than $169bn in assets, he has been crowned one of the worlds most successful investors of all time, founding Bridgewater Associates in 1975. Here is his take on how the economy works – he’s worth listening to!
Britain’s decision to exit the European Union was a shock to many and has brought with it all the expected trappings of a wild news event – projections of crazy market volatility, doom gloom, recessions and wild headlines.
Many questions immediately arise as we pay close attention to how the event will play out in the weeks and months to come. But our perspective is the same as it has always been in times like these. Your financial plan is built with diversification and your personal risk tolerance in mind — it’s designed to weather the ups and downs that inevitably follow significant world happenings.
1. What did British voters decide?
To the surprise of many – including stock and bond markets – Britain voted to leave the European Union (EU) by a margin of 52 percent in favour of leaving (i.e., “Brexit”) and 48 percent in favour of remaining. The general belief from the economic community is that this decision will weaken the British and European economies since Britain both imported and exported a significant amount of its economic consumption and production, respectively, to continental Europe.
2. How have markets reacted?
At the time of this writing, stock markets have fallen and bond interest rates have dropped as well. With the exception of precious metals, commodity markets are also generally down, and the Pound has dropped by about 8 percent against the U.S. dollar.
3. Why have markets reacted so violently?
Without question, the primary reason is that markets had incorporated a belief that Britain would remain in the EU. Stock markets had been up significantly over the last couple of weeks, and interest rates had started to move back up after being lower earlier in the month. These movements were generally believed to be an indication that the market expected Britain would remain in the EU.
Because the vote did not go as most expected, stock markets are giving back those gains and more, and interest rates are now falling instead of increasing. I should emphasise, though, that while these market moves have been swift, this is normal market behaviour when a significant event (like Britain leaving the EU) turns out differently than what the market had anticipated.
4. Why have the international markets reacted so strongly to Britain’s decision?
We truly live in an interconnected, global economy at this point. Any decision by an economy that is the size of Britain’s (fifth largest in the world) will impact markets elsewhere, including the U.S. market. The European market is a significant trading partner for many U.S. firms, so it’s not surprising to see U.S. and international stocks decline since Britain’s decision is thought to be a net negative for Europe from an economic perspective.
5. Will Britain’s decision precipitate a global recession?
It’s impossible to say whether we are headed toward a recession, but Britain’s decision likely increased the likelihood of a recession. However, the strong caveat here is that markets are forward looking and have already started to incorporate this likelihood, meaning you can’t use this information to your advantage. This increased likelihood of recession is no doubt one of the reasons that stock markets have moved down sharply while bond prices have moved up sharply.
6. How did markets get this wrong?
While outguessing markets is difficult, in hindsight markets will always appear to have been overly optimistic or pessimistic, which means it’s easy to critique them while looking in the rearview mirror. This particular vote was expected to be close, so markets weren’t certain but were trending toward a “remain” vote.
7. What will markets do from here?
While it’s very difficult to predict markets, it is highly likely markets will be volatile for some time to come. Stock market volatility has been relatively low over the last few years, but it can change quickly. The VIX, which is a measure of annualised stock market volatility, has gone from about 17 percent to 25 percent in reaction to the news, which is higher than the long-term average of about 20 percent per year.
It is important to remember, however, that higher volatility can work in both directions. While we could certainly see more days when stocks fall significantly, it’s also possible we will have days when they rise significantly.
8. What should I do with my own portfolio?
Our guidance is the same that it has always been. If you have built a well-thought-out investment plan that incorporates your ability, willingness and need to take risk, you should not change your plan in reaction to market events. Doing so rarely leads to productive results.
Your plan incorporates the certainty that we will go through periods of negative market returns, and market reactions like this are also the primary reason we emphasise high quality bond funds and bond portfolios, which help buffer the risk of stocks. The early read on this bond approach is that it’s doing exactly what we expect it to since high quality bonds have appreciated significantly in reaction to the Brexit vote.
9. How will this impact interest rate policy?
As we have previously noted, interest rates have dropped dramatically in reaction to the vote. At the closing bell on Friday, the 10-year yield was at about 1.088 percent after having been at about 1.376 percent one day earlier. These early movements in interest rates indicate the market does not expect the Bank of England to increase interest rates at any point during the rest of the year. The primary ways this would likely change are either an unexpected increase in the rate of inflation or unexpectedly positive developments in the British and global economy.
10. Do international and emerging markets stocks still deserve a place in a well-diversified portfolio?
International and emerging markets stocks comprise more than half of the world’s equity market value, so we continue to believe that a well-diversified stock portfolio should include a significant allocation to international and emerging markets stocks. While both have outperformed British equities over the last 10 years – international also over five years, that does not mean they will continue to do so. We have seen periods in the past when British stocks have outperformed international and emerging market stocks for a long period of time only for that to reverse in the future.
11. What role do currencies play in this situation and in my portfolio?
Initially, we are seeing the British pound depreciate against the Euro and U.S. dollar. The international equity funds we use do not hedge foreign currency, so when the British pound depreciates relative to other currencies, this positively impacts their returns. The long-run academic evidence, however, shows that hedging currency risk has minimal impact on an overall portfolio and that it can be beneficial to have exposure to currencies other than the British pound for a portion of an overall portfolio.
12. Yield Curve
A yield curve shows the yield or ‘interest’ payable on varying term fixed interest securities (typically Gilts/government bonds). Shorter term normally have a lower yield than longer term fixed-interest securities.
Research beginning in the late 1980s documents that the slope of the yield curve is a reliable predictor of future real economic activity i.e. a recession predictor. Today, a substantial body of evidence exists from which various useful stylised facts have emerged.
An inverted yield curve is often a predictor of a recession. At present, although the reducing, the 3-month yield vs 10-year yield remains positive. Typically yields become inverse or the difference is negative 3-6 months before a recession occurs.
As always, if you have any questions please feel free to contact Lexington on 01793 771093 or [email protected].
The ignominy that goes with making bold forecasts was highlighted in a recent newspaper article, which listed many bad calls US economists had made about 2015. These included getting the timing of the Federal Reserve’s interest rate increase wrong, incorrectly calling for a rise in long-term bond yields and assuming an end to the commodity rout.
In the UK, a poll of 49 fund managers, traders and strategists published in early January 2015 forecast the FTSE 100 index would be at 6,800 by mid-year and 7,000 points by year-end. As it turned out, the FTSE surpassed that year-end target by late April to hit a record high of 7103, before retracing to 6242 by year-end.
For the broad US equity market, 22 strategists polled by the Wall Street Journal estimated an average increase for the S&P 500 of 8.2% for 2015. The most optimistic individual forecast was for a rise of 14%. The least optimistic was 2%. No-one picked a fall. As it turned out, the benchmark ended marginally lower for the year.
Australian economists were little better. A January 2015 Fairfax Media poll found the consensus view was that local official interest rates would stay on hold all year. The Reserve Bank of Australia proved that wrong a month later, before cutting rates again in May.
It shouldn’t be a surprise that if economists can’t get the broad variables right, it must be tough for stock analysts to pick winners. Even a stock like Apple, which for so many years surprised on the upside, disappointed some forecasters last year with a 4.6% decline.
In Australia, among the “Top Picks for 2015” published by one media outlet a year ago were such names as Woodside Petroleum, BHP Billiton, Origin Energy and Slater & Gordon, all of which suffered double-digit losses in the past year.
It should be evident by now that setting your investment course based on someone’s stock picks or expectations for interest rates, the economy or currencies is not a viable way of building wealth in the long term. Markets have a way of confounding your expectations. So the better option is stay broadly diversified and, with the help of an adviser, set an asset allocation that matches your own risk appetite, goals and circumstances.
Of course, this doesn’t stop you or anyone else having or expressing an opinion about the future. We are all free to speculate about what might happen in the economy and markets. The danger is when you base your investment strategy on an opinion.
In the meantime, if you insist on setting store by forecasts, here is a list of ten predictions you can count on coming true in 2016:
1. Markets will go up some of the time and down some of the time.
2. There will be unexpected news. Some of this will move prices.
3. Acres of newsprint will be devoted to the likely path of interest rates.
4. Acres more will speculate on China’s growth outlook.
5. TV pundits will frequently and loudly debate short-term market direction.
6. Some economies will strengthen. Others will weaken. These change year to year.
7. Some companies will prosper. Others will falter. These change year to year.
8. Parts of your portfolio will do better than other parts. We don’t know which.
9. A new book will say the rules no longer work and everything has changed.
10. Another new book will say nothing has really changed and the old rules still apply.
You can see from that list that if forecasts are so hard to get right, you are better off keeping them as generic as possible. Like a weather forecaster predicting wind, hail, heat and cold over a single day, your audience will prepare themselves for all climates.
The future is always uncertain. There are always unexpected events. Some will turn out worse than you expect; others will turn out better. The only sustainable approach to that uncertainty is to focus on what you can control.
In the meantime, let me wish a happy New Year to you all.
In a week where the City usually heads to the beach for summer, traders were ambushed by a wave of volatility.
The previous week’s devaluation of the Chinese yuan was followed by the release of poor Chinese manufacturing data that fueled concerns about slowing global growth. The damage had previously been contained to cyclically-sensitive companies like transportation, commodities, industrials and sub-segments of technology, but last week it spilled over to all risky assets. The FTSE 100 fell 5.5%. This was the biggest weekly point decline since the middle of the financial crisis.
The volatility spilled into this week beginning with a rout in Asia when Chinese policy makers failed to cut rates or bank reserve ratios as investors expected. This pushed the Shanghai Index down 8.5%. This is the ninth consecutive day of losses and it is now down more than 20% from highs achieved in April. The carnage moved westward with most European markets down approximately 4%.
While there are legitimate concerns about global growth decelerating, we view the chance of a recession as minimal. Since historically this is the cause of the vast majority of “bear” markets (defined as a drop of 20%-plus), we feel we are simply witnessing a stock market correction. Undoubtedly these are uncomfortable, but it’s important to remember that successful long-term investing requires fortitude during these cleansing periods. It is during these stressful radical moves that investors with long time horizons can pick up the proverbial baby thrown out with the bath water. We recognise that these situations are dynamic and are continuously monitoring market developments, but we remain true to time-tested investment discipline and process.
Investors who succeed do so long-term by sticking to their plan, especially when the markets are dicey.
The current market volatility is uncomfortable, but it’s not unusual or unexpected.
