As I was penning the title of this commentary, it reminded me of early 70’s TV series called “Upstairs, Downstairs.” Upstairs, Downstairs was a British television drama series that ran for 68 episodes. Set in a large townhouse in central London, the series depicts the servants—"downstairs"—and their masters, the family—"upstairs"—between the years 1903 and 1930, and shows the slow decline of the British aristocracy. Great events feature prominently in each episode but minor or gradual changes are also noted. The show stands as a document of the social and technological changes that occurred during those 27 years, including the Edwardian period, women's suffrage, the First World War, the Roaring Twenties, and the Wall Street Crash.
Similarly, investing today requires an awareness of both the gradual and sudden changes that are impacting the financial markets, so that portfolios can be positioned properly. The challenge is to be prepared for the potential negative shocks, but also be positioned to take advantage of the changes and innovations that drive growth. It is not an exaggeration to say that today’s financial markets are presenting one of the most challenging investing environments in decades.
When interest rates rise so fast and so high in such a short period of time, both stocks and bonds will always suffer hefty declines. The bear market (as defined by a 20% or greater decline) in stocks that occurred this year was mainly due to the violent and sudden end to the longest bond bull market in the last 50 years. Equities and fixed income valuations after this year’s sell off are more reasonable, but despite the forward-looking nature of the stock market, it is possible that the market has not yet accounted for a disappointing Q2 earning season (companies are just beginning to report Q2 earnings at the time of this writing).
When thinking about how to best position portfolios for the coming quarter, it’s helpful to think about the possible events that could impact the markets, and the probabilities of those events being an “upside surprise” or a “downside surprise:”
Here are four examples:
New COVID treatments/vaccines relegate the virus to a small annoyance, and the global population reaches herd immunity and puts the pandemic firmly in the history books. Possible? Yes. Likely? No.
New COVID variants (and/or more severe) re-introduce restrictions and hamper global economic growth. Possible? Yes. Likely? Maybe.
The Federal Reserve orchestrates a soft landing and manages to tame inflation and not send our economy into a recession. Possible? Maybe. Likely? Not a chance.
The Federal Reserve pushes up interest rates too far, unemployment accelerates, inflation remains a big problem, and the U.S. suffers from a recession. Possible? Yes. Likely? Maybe.
Russia and Ukraine find a path to quickly end their war, Europe avoids an energy crisis as trade resumes to pre-war levels, and global economic growth accelerates as the U.S and China thaw their current chilly relations. Possible? Maybe. Likely? Highly doubtful.
The Russia and Ukraine war expands by possibly dragging other countries into conflict, complicating global trade and exacerbating inflation. U.S. and China relations deteriorate further, and economic activity slows. Possible? Yes. Likely? Maybe.
Despite higher costs, companies report strong Q2 earnings and convince investors that they can continue to manage a tight labor market and double-digit inflation. Possible? Maybe. Likely? Doubtful.
Q2 earnings disappoint, but, even worse, firms warn that future earnings may also disappoint due to continued supply chain disruptions, higher costs and lower demand. Possible? Yes. Likely? Maybe.
In the above examples, downside risk seems more probable than upside risk. Unsurprisingly, investor “sentiment” is close to historical lows, but that does provide some comfort as it can serve as a classic contrarian indicator.
We generally strive to protect more for the inevitable “downsides” even if that means not fully enjoying the resulting “upsides.”
We will continue to carefully monitor market developments and welcome the opportunity to speak with clients in more detail about portfolio strategies.