Downing Fox Investment Letter - Q3 July 2023

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It’s never been harder to be a cautious investor. Not within most of our working lives, anyway. This is unfortunate because there have never been so many cautious investors.

It’s no coincidence. The outsized baby-boom generation are all hitting retirement at the same time, and the textbook tells them to hold “lower risk” assets. Then Economics 101 says rising demand for an asset (without rising supply) makes its price rise, while Investing 101 says if an asset’s price rises (without its fundamentals improving) it becomes higher risk.  

Which means the riskiness of cautious assets has risen just as people need cautious assets. Oh, what a wicked web we’ve weaved!

How can you negotiate this web? I see three big dilemmas¹ to wrestle with. They are:

1. Equities are (I believe) safer assets over the long term, but are volatile in the short term.
2. Assets that defend well in one sell-off can fare badly in the next.
3. Some assets defend well in small sell-offs, but collapse in large ones.

The rest of this article is about these dilemmas.

Dilemma #1: equities are long-term safe, but short-term risky  

You already know which asset class I’m personally backing: It’s equities (see my previous article for why). If you can stretch your time horizon - which I can - then I believe equities are a lower-risk, higher-return option than the textbook cautious alternatives: cash and bonds.  

Chart 1, below, (taken from our Q2 letter), shows how judging UK equities by a) using longer time periods and b) including the corrosive impact of inflation, can make them a safer option than gilts (and bonds in general) or cash, and with potentially higher returns too. 

Safer and higher returns? That shouldn’t happen, right?

Nope. But because humans are continually foxed by short-term market volatility and the slow, sneaky damage caused by inflation, it does.

Inflation matters because most sell-offs are caused by an impending recession, which means deflation. These are like a heavy downpour – nasty, but they pass, and you can find shelter in bonds or cash while it does. Inflation, in contrast, is like a tsunami; your best bet is to try to outrun it. Gilts and cash won’t do that, but equities have at least a chance.

The reality is, sadly, that this philosophical leap – that the most cautious option is being less cautious - won’t work for most. Convincing a nervy client to stretch their time horizon is like recommending a sweet-toothed friend switch to a sugar-free diet: No matter how much they want to do it, you know they’ll cave at the first sight of a doughnut.

For cautious investors, the equivalent of a doughnut is an equity market sell-off. In the midst of one, they simply cannot resist panic selling their holdings, and at the worst time too.

You could try hiding their regular portfolio statements. But this is frowned on by the regulator; is easily circumvented by the disaster-hungry client; and only makes them angry while you’re doing it. Good luck if you try this route.

Dilemma #2: there’s more than one type of sell-off

As (too) many investors found out last year, sometimes assets that look safe turn out not to be. I’m looking at you, Mr Bond.

Government bonds (“Gilts” in the UK, “Treasuries” in the US) are often referred to as “risk free” in the industry, but last year they were anything but (nothing’s risk-free by the way, that term should be retired without benefits). If you’re of a financially sensitive disposition, look away from Chart 2 now:

This is a far cry from what gilt holders experienced in the Global Financial Crisis in 2008, which looked like this:

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So, what changed? Why didn’t gilts defend in 2022 as they did in 2008?

The answer, as I’m sure you knew, is inflation. The Global Financial Crisis was a giant recession, and recessions are typically deflationary events (falling spending in an economy causes the level of prices to fall/deflate, not rise/inflate). The fixed income offered by gilts became more attractive, as a fixed income is a better shelter than the falling income likely from other assets, such as equities and property. So, demand for gilts rose, causing their prices to do the same.

But 2022 was an inflationary wave. The economy didn’t go into recession, and everyday prices rose sharply. Gilts’ fixed income and capital suddenly looked a dangerous place to hide when the prices of other stuff - notably natural resources - were rising fast. So, demand for gilts fell, causing their prices to fall too. If you held bonds, in other words, you were sheltering in a leaky shed just as a tidal wave ripped through.

Clearly what ‘type’ of sell-off you’re likely to experience next matters. A lot. Unfortunately, despite what the papers and tellyconomists might tell you, there is no reliable way to predict the next sell-off’s ‘type’, or when it will be.

But one way to avoid the risk of falling gilt prices (but not high inflation) is to shun them for cash, because cash never drops sharply^[1]. But even this isn’t simple. Because if you’re hit by the wrong ‘type’ of sell-off, your portfolio can end up looking riskier than one that used gilts instead (even if, by avoiding gilts, you had actually cut the risk of inflationary damage, a.k.a. “duration risk”). The following charts illustrate this effect, using two portfolios of 40% equities, but one balanced by 60% cash, and the other by 60% gilts.

Taking the arguably lower risk option of cash to counterbalance your equities looked like you took more risk in 2008. This is because the higher volatility of gilts can be a good thing, but only if their prices are spiking higher while equities are gapping down (i.e. “negative correlation”).

This is what usually happens with gilts. But not last year: Their prices fell in tandem with equities due to the inflationary nature of the scare. Which is why the situation flipped; unlike in 2008, in 2022 using cash as your equity counterbalance looked (and was) the more appropriately cautious option.

Fast forward to today, and we’ve already seen both of these scenarios play out in 2023, albeit in smaller episodes. Given how sensitive cautious investors are after the horrors of 2022, this is not helpful. Chart 5 shows this playing out for those two portfolios at different points this year:

This dilemma, we think, is now the hardest of the three. We say “now”, because at the start of 2022 it wasn’t that hard: The low yields on gilts meant that, even if the next sell-off had been deflationary, they wouldn’t have performed that much better than cash. So, given the sizable risk an unexpected return of inflation posed to bonds, holding cash instead of them was a no brainer.

But now bonds are back on higher yields after their hiding last year, so they do offer a decent level of insurance against a deflationary recession – something our central bank seems dead set on bringing about. But, at the same time, this uptick in inflation looks stubborn. Whether inflation stays, rises or goes isn’t something we can call. So we don’t try. This differentiates us from many of our peers, who also can’t call it, but will give it a go anyway.

So, because we’ll never back just one horse in an even two-horse race, particularly in the impossible-to-predict world of macroeconomics, today our non-equity portfolio is a mix of gilts (with some US Treasuries) and cash (roughly a 60-40 mix).

As such, in either ‘type’ of sell off, we’re no longer likely to be the very best performer but, more importantly, we’re unlikely to be the very worst either. And we think that avoiding catastrophe matters most to the cautious investor.

Dilemma #3: Big sell-offs are different to little ones

There are minor sell offs, let’s call these “ticks”, and there are major sell offs, which we’ll call “booms”. And there are many more ticks than there are booms. (By “minor”, I mean a sell-off that doesn’t get its own book.)

Dilemma #3 is that some assets defend well in ticks but collapse in booms. This can hurt because, for every tick in which a false-defender does well, it’s natural to add more of them to your portfolio; it feels like you’re making it safer. But you’re not. Quite the opposite: when the boom strikes, a false sense of security means you’re driving faster and your brakes will fail – just when you really need them.

High-yield corporate bonds are a good example. There’s nothing wrong with these assets – a good manager can make you decent returns over the long run. But they’re often added to the part of a multi-asset portfolio that’s meant to dilute equity falls in a bear market. The trouble is, they look like equity diversifiers in minor sell-offs - and the data will tell you as much too - but when it all really hits the fan in that once-a-decade way it always does, they usually head the same direction as equities: south.

Chart 6, below, shows this happening before the Financial Crisis in 2008. There were a handful of minor stock market wobbles in the two years before^[3]. In each of these ticks, high-yield bonds held their ground while share prices plunged. In fact, in the final wobble before The Big One, high-yield bonds actually stayed flat while the classic defenders - gilts - fell back.

So, if you held gilts instead of high-yield bonds in the tick of May 2008, you looked riskier. This, and the fact that high-yield bonds rose faster in the non-wobbly periods too, encouraged many investors to swap out gilts for high-yield bonds. Then… boom! In an actual crisis - not a minor panic - their “equity-diversifier” bucket collapsed in tandem with the equities they were meant to be diversifying (while those who stuck with gilts enjoyed the offset as gilt prices rose).

We’ve seen something similar in the two relatively minor ticks we’ve had in 2023. In both, high-yield bonds have stood up well. The first was sparked by the collapse of SVB Bank, the second by markets taking fright at the persistence of inflation. In the latter, high-yield actually rose, while the classic defender – gilts – fell.

I don’t mean to single out high-yield as a portfolio villain: It’s a perfectly valid asset class. My point is that if you divide your portfolio up into “attack” and “defence”, as we do, then we think high-yield bonds (which are – remember - loans to lower-quality companies) should sit with equities in the “attack” part, and not in “defence”^[4]. The same goes for many other alternative assets that are little more than equities in bond clothing.

We know, however, that many multi-asset products, perhaps led by data from recent ticks and not booms, classify these assets as “equity diversifiers”. I just don’t think that will end well if we do finally see this long-heralded recession.

What’s our approach to dealing with this dilemma? Firstly it’s to set our stall out clearly. We define how much equity (“attack”) each portfolio holds and commit to holding the rest in genuine equity diluters (“defence” – for us that’s only cash and/or government bonds). Then we stick to those levels, particularly by not sneaking equity lookalikes into the non-equity bucket. It’s then down to you how much you choose of each.

We also focus on what’s most likely to dilute equities in the booms, rather than the ticks. Don’t get me wrong, we want to defend well in the ticks too, but if you can’t have both - and sometimes you can’t - we prioritise booms. These are the events that make the Ten O’Clock news and, therefore, are the ones that will most alarm your clients. That’s when you want to avoid nasty surprises from your portfolios.

I’m conscious I haven’t given you cut-out-and-keep answers to these dilemmas. But that’s why they’re dilemmas: They’re hard, and they almost certainly don’t have a perfectly pleasant solution. I think it’s important for you to know that though – sugar coating it, particularly by implying there’s a magic silver-bullet solution, will likely lead to disappointment down the line.

From the Fox perspective, we think good balance is the least bad answer (as we do to most investment problems). We view survival (of a portfolio, of a client relationship, of a business etc.) as being the first, necessary ingredient of success (necessary, but not by itself sufficient). That sounds obvious, but it’s amazing how many managers will risk everything on one outcome - either intentionally or by accident - when a plausible alternative outcome kills their portfolio, and with it your credibility as a trusted client adviser.

OK. I’m pushing my luck with the wordcount again. Any questions, you know where we are. Good luck out there…

Simon Evan-Cook

Fund Manager, VT Downing Fox Funds

If you'd like to subscribe to receive updates from Simon email downingfundmanagers@downing.co.uk. 

Footnotes

_{[1] “Dilemma” is a word, like “decimate”, that I get irritatingly anal about. A dilemma is a choice between two unpleasant options. So, for most people, having to choose between Mamma Mia! or Moulin Rouge! in the West End is not a dilemma, but a tricky decision between two appealing shows. But for me it’s a dilemma: I hate musicals and, given the choice, I’d take option 3; an evening of having my leg hair removed with gaffer tape.}

^{[2] Heading off the pedants: I mean in nominal terms. Clearly cash’s value can drop sharply, as it did in Zimbabwe a few years back, but even there its nominal level didn’t drop.}

^{[3] When a sell-off starts, it doesn’t know how big it will be. All major crashes and bear markets start off as ticks (the same as the countless tiny market falls we see every day of every week). They then just “go viral”, gathering more sellers, as whatever worry sparked the tick grows large enough to turn it into a boom. This chaotic nature is why sell-offs, like earthquakes, are impossible to reliably predict.}

^{[4] In their defence, recent conditions have been Goldilockesque for high-yield bonds – a bit of inflation and some economic growth suit them pretty well. They pay a nice level of income if you need it too. They still won’t enjoy a recession though…}

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