Crystal Wealth Newsroom

Market update: Volatility returns, meaning a longer-term view is required


If you’re following the media’s reporting of the financial landscape at present, it’s very much ‘risk on, risk off again’ news flow. One week the economic data looks stronger, inflation is going to be more of a problem, and then rates will need to keep rising, all of which is seen as a negative for markets. Then the next week, the data doesn’t look as strong, central banks may be able to pause monetary tightening, and some sort of ‘soft’ landing scenario comes back into view. Then we can overlay this with recent banking issues, the topical one being the crisis around Silicon Valley Bank (SVB).

In short, SVB had a mismatch between its short-term borrowings (i.e. bank deposits) and longer-term investments (i.e. bonds and other securities). Once the price of money started going up, deposit flows stopped as depositors needed the cashback (particularly start-ups), and the bank’s underlying assets had to be redeemed to meet these outflows.

Unfortunately, without adequate interest rate hedging, a mismatch emerged, leading to a loss on asset sales and hence panic about potential deposit balances.

Then the regulators stepped in to guarantee all deposits and provide a central bank liquidity backstop for bank deposits more broadly. Put simply, a mechanism to stop fears of a broader-based run on the banks developing through the actions of one idiosyncratic participant.

As a result, volatility is up considerably across both bond and equity markets as debate continues about the next steps in current monetary policy thinking, including the level of interest rates.

This naturally creates a challenging investment environment in the short term, however, there are some broader themes that we can focus on above the week-to-week market movements.

Inflation: ‘whatever it takes’

The first is that inflation is very likely to be brought under control by the current action of central banks – we’ve heard the ‘whatever it takes’ rhetoric from central banks globally and currently, this is still a prime focus.

The real underlying issue is the contraction in credit supply within the financial system that has been introduced amid the ‘inflationary assault’.  The supply of credit supports growth and drives inflation within an economy.  Just as the excess creation of money throughout the pandemic fed an inflationary surge, its rapid destruction through reducing the money supply (i.e. tighter money) can be disinflationary.

It is the process of restricting credit and withdrawing general liquidity within the financial system that ultimately highlights pockets of weaknesses. Central banks have addressed general banking liquidity through current supporting mechanisms, however, the tightness of bank credit to businesses will be the real test for the economy.

It is for these reasons, that commentary has turned to how much further rates can go before further cracks open up, and we see some easing again as a result. In that regard, recent events certainly suggest we are getting closer to the ‘pause’ button as the next step in the process.  In fact, current bond market pricing suggests rate cuts may need to come sooner than later.

Of course, the question that naturally follows such market ructions is whether that will bring forward a recession. The historical data points to ‘yes’ when rates increase that sharply and credit conditions tighten, however, this is coming off the back of a global pandemic and unprecedented policy action and government support. This makes the position far more difficult to read, as evidenced by relative ongoing economic strength to date. This time it is unlikely to be so straightforward, but clearly, plenty of risks remain.

Geopolitical tensions continue to impact

Other themes to consider when putting together portfolio positions currently include geopolitical tensions and the impact they continue to have on the market, as well as the repricing of a number of asset classes based on higher cash rates. This is still to work its way through the system, particularly in areas such as private credit, private equity and various unlisted property assets.

Monetary policy operates with a lag effect, which makes the adjustment process tricky to manage for central banks, although the recent banking shock suggests those lags may not be so long and variable after all.

We fully expect the negative headlines to continue for some time yet, and further ‘surprises’ to emerge as a result of tighter monetary policy. However, it is quite possible that inflation could surprise us by the end of the year, and once it starts falling, it rapidly continues to do so.

This has partly been the pattern of what we’ve seen post-COVID. We’ve had more wild swings where something’s gone up more than expected before it turns around and does the exact reverse. This increased level of oscillation has been caused by the artificially low-interest-rate setting for too long, making any upward adjustment now more dramatic.

Over the coming months, we expect the market volatility to continue – markets will react to interest rates, inflation figures and growth data, which means it’s important to look out a little further and focus on cash flow needs right now.

Central banks will be highly sensitive to signs that the financial system is struggling and the flow of credit to businesses is stalling.  This means, undoubtedly, current market events will feed into the current ‘inflation/rate’ policy mix.

Positives on the horizon?

In the near term, there are plausible scenarios for markets to become more positive (e.g. China growth offsetting slowdowns elsewhere, rates pausing and/or lowering ahead of schedule), and there are also very plausible scenarios for markets to struggle further – generally driven by central banks overdoing the tightening precipitating a more severe recession.

It is also important to remember that there are different dynamics affecting different countries – we’re not all on the same path, although the underlying issues may be similar, the timing and degree are different – so the response is also likely to emerge in different ways.

As an investor, it’s important not to be reactionary. Generally, once the news is in a headline, it is too late to act. Chasing asset returns isn’t advisable if indeed possible, given the problems with market timing and, as always, risk relative to return matters most here.

Markets rarely mirror economics, and we are not on a linear path. It is likely we remain in a period of heightened volatility over the coming days and weeks, and this just reinforces the importance of managing to a longer-term strategy.

It means having portfolios capable of handling different scenarios – diversification is hugely important but within the context of dealing with both ‘positive’ and ‘negative’ market outcomes.

Of course, no one really knows what the full effect is going to be over the coming months, however, looking forward, the higher level of income being generated within portfolios now (based on higher cash rates) should help cushion overall asset price volatility. We also expect opportunities to emerge as assets misprice at various times in response to market news, which means remaining flexible with total asset allocation settings.

What is certain, however, is we are now seeing the results of the last 12 months of monetary policy play out, and this means keeping a close eye on what’s going on, managing the portfolio’s strategy and not reacting to the latest headlines.

If you’d like to discuss how the market is performing, and what that means for your investments, please contact the team here at Crystal Wealth, who’ll be delighted to help.

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