Beyond the volatility

This quarter, we’ve thought a lot about volatility. Equities experienced a significant bout of it at the beginning of August when weaker-than-expected US jobs data spooked the markets. A rapidly strengthening Japanese Yen added weight to investors’ fears. But a couple of months later, the economic landscape has returned to relative calm, with most assets ending the period either flat or higher. The summer’s panicked headlines never really came to fruition, but it was easy to get caught up in all the drama.

The word volatility comes from the Latin volatilis meaning fleeting, transitory, swift and rapid, also ‘evaporating rapidly’. When volatility hits markets, the etymology of the word says it all: in all likelihood, it isn’t going to stick around for long. But it does create a lot of noise, and this can elicit fear, causing some investors to diverge from their long-term investment plan.

Economics works in long cycles, moving circularly from expansion to contraction. During expansion we see growth and rising employment. The flow of money through the economy is healthy. That reverses during periods of contraction, when growth and employment slow and the economy starts to stagnate. These cycles can take decades to complete, but some can be much quicker.

As long-term investors, we look for signs of change in economic cycles. We try to avoid getting caught up in volatility, instead seeking long-term trends with solid fundamentals. Long-term investing does not heed quick results, so those wanting to participate will need plenty of patience. We believe this attribute is crucial to the success of this investment strategy.

We live in a noisy world, with thousands of data at our fingertips and international news reported 24 hours a day. Some of this information is valuable, but it can be hard to identify in amongst all the noise. As long-term investors, it’s crucial we distinguish noise, or short-term volatility, from what really matters: signals, or directional moves in markets.

In 1986, the economist Fisher Black wrote a seminal paper on noise, defining it as “contrasting with information”. He continued, “People sometimes trade on noise as if it were information. If they expect to make profits from noise trading, they are incorrect.”¹. We largely agree with Black; we are not an investment house which favours short-term volatility trading. So, our interpretation of the yoyoing bond markets over the summer really mattered. Was it an important signal? Or was it merely noise?

We agreed it was the latter. As such, the big pendulum swing in fixed income over the hottest months of the year didn’t concern us too much. We interpreted it as a reflective dance between policy, what’s expected of policy, and what’s anticipated for economic growth. Expectations for upcoming interest rate cuts fell from seven in January, to potentially no cuts at all. That’s a huge change, which took bond markets backwards and forwards. Now things have settled down, bonds are now trading at roughly the same levels they were a few months ago. You might have blinked and missed all the noisy drama, no signals in sight.

These shifts didn’t change our long-term investment strategy; we knew this yoyoing was not a secular shift. But the noise did serve the useful purpose of showing us the inherent vulnerabilities of the bond market. It gave us a glimpse into what might happen if the long-term tide does truly change, a peek into the possible, or a warning of what might come.

What we learned was to beware of some overexposed trades; a few of the winners of the past may face reversal when sentiment changes. Those investors who had been overly exposed to the yen carry trade (borrowing in low-yielding yen and parking the money in high yielding places, like the Mexican peso) learnt this lesson the hard way. Especially those who had been using the highest leverage.

As a reliable economic indicator, noise is full of flaws. But this summer, fixed income’s short-term volatility did undoubtably offer us a few useful insights into future possibilities.

¹ Noise (wiley.com)

It’s a tight race for US presidential candidates Kamala Harris and Donald Trump. At the time of writing, the vote is thought to hinge on crucial swing state Pennsylvania, where teams from both sides will no doubt be swarming to charm the undecideds.

As long-term investors, we try not to get too distracted by short-term political noise which mostly just rattles volatility. The next White House resident is unlikely to engender any long-term secular shifts; the horse (the US economy) matters more than the jockey (the President). But they will create some short-term fluctuations. It’s important for us to be cognisant of both candidates’ policies and their potential near-term impact on markets.

The Republican candidate Donald Trump wants growth, and his policies are generally pro-business and inflationary. If the former President returns to the White House he plans to cut taxes, extending the provision of his Tax Cuts and Jobs Act which was signed into law in 2017. This Act is due to expire in 2025, but lower taxes are popular so either candidate may extend it. Lower taxes put money in peoples’ pockets, so they spend more. This would be positive for markets and equities, but it would also push up inflation.

If Trump’s former term is anything to go by, he is likely to implement trade tariffs to stop the inflow of cheaper Chinese goods and bring manufacturing back to the US. This means producing goods in the US dollar which would be very expensive due to the currency’s recent strength. This would also push up inflation. Trump plans to cut immigration which would lead to a shortage of labour supply. That means those employed can ask for higher wages, also pushing up inflation.

The Democrat candidate Kamala Harris wants to cut immigration too, but her plans on this contentious issue are a little milder than Trump’s. She also plans personal tax cuts, for those earning under $400,000. This puts more money in peoples’ pockets and stimulates demand which is good for business. But she also plans to increase corporation tax, squeezing net margins, which would be tough on equities and business. In a way, she plans to give to business and individuals through tax breaks and lower tax, but then take from them by hiking up corporation tax. It’s hard to predict which of these contradicting forces will prevail.

Either way, we think bonds are the asset to avoid. The US has a huge debt overhang which needs to be addressed by whoever takes the White House. Both candidates are actually projected to increase the deficit, with a clean sweep in either direction looking particularly ominous for those concerned about the current budget deficit increasing further. The obvious solution is to issue Treasuries, which will put the asset into oversupply. If inflation rises again, interest rates won’t come down anytime soon and the price of US debt will suffer. Investors seeking inflation protection are looking to gold instead.

Volatility has swept through Japan this year. A small, long-awaited uptick in their inflation prompted the Bank of Japan unexpectedly to raise interest rates from 0.1% to 0.2% as everyone else was cutting theirs. Higher interest rates tend to push up the value of the currency, and the Japanese Yen rose sharply in response. This quickly unwound billions of dollars of short Yen positions, causing a huge spike in volatility. Japanese equities sold off roughly 20% before recovering c. 10% in following days, causing enormous unrest in markets.

This volatility rattled investors, many of whom were reclining on sun loungers enjoying their summer break. Volatility over the sunny season can be accentuated by an absence of investors on the ground. Trading is thin.

A couple of months later, where are we? Markets have settled down; the volatility has not significantly changed the landscape of the Japanese economy. The end of disinflation, cheap valuations and improving fundamentals write a strong long-term investment case for the country. Former Prime Minister Shinzo Abe’s 2012 policies are beginning to come to fruition and there’s now a much greater focus on shareholder value. We expect the return on equity to increase, and that would be an important driver for future returns. The Yen has been cheap for years, but it still looks undervalued now. At some point, it has to rise.

Some signs of economic success are starting to emerge, including an increase in high profile takeover activity, particularly from foreign buyers. After languishing in the doldrums, unloved by investors for years, Japanese equities were one of the best performing stock indices in 2023.

The noisy volatility in Japanese equities over the summer had nothing to do with their fundamentals. The asset class itself was not the primary issue; it was simply short-term collateral damage of the very rapid unwinding of the yen carry trade. To us, Japan is an attractive long-term opportunity. We have identified it as a prime place for active management at a portfolio company level, with engagement. Our Japanese exposure includes a fund which viewed the summer volatility as an opportunity, buying undervalued companies with strong fundamentals; a decision which has driven robust positive performance.

The dance between policy, interest rates and inflation continues. The repercussions are most evident in bond markets which have swung vividly as rate cut expectations shifted between seven and none at all, as data have variously improved and worsened. There’s been a lot of volatility, but markets have ended up trading sideways.

In a world of infinite possibility, we have looked at today’s policy and market activity and tried to condense our predictions of the future into three pathways. The first scenario is recessionary. It says there’s a possibility growth is already slowing, and the slowdown will continue until we reach recession. Scenario two is also recessionary, but it makes different assumptions about the current state of the economy and route to slowdown. The second scenario says the economy has slowed a little but will remain strong, however, persistent inflation and higher interest rates will eventually lead us to a slowdown.

The third scenario paints an altogether more optimistic picture. It says we escape a slowdown completely due to the efficiency and productivity gains realised by artificial intelligence (AI). Prices will come down, inflationary pressures will dissipate, interest rates will normalise, and economic growth will accelerate. Although this is possible, we think this is probably a long shot. Productivity gains due to AI will potentially come, but too late for this period of economic growth.

Recent data in the US indicate that scenario two looks more likely. Markets have repriced expectations for interest rate cuts, and assets that will do well in scenario two have seen strong performance lately. Although the waters have been muddied by US services and manufacturing issuing conflicting messages. The former indicates economic expansion and the latter contraction, pointing us towards scenario one. Economics is rarely clearcut.

Short-term expectations for interest rates and inflation are very important. We’ve got used to Central Banks all largely pointing in one direction, which made monetary policy easier. But now there’s divergence in the path of rate cuts, a few Central Banks actually increased theirs when most others were being reduced.

It’s hard to see where a significant positive impulse is going to come from. The Fed has now begun to reduce rates but that doesn’t prevent a recession; there’s a lag to the effectiveness of rate cuts. Realistically, if inflation is stickier than expected, interest rates are probably going to stay where they are now, or even increase.

Higher for longer rates present bond markets with a challenge. They are hoping for a 2% cut in the next couple of years, but growth would have to slow significantly for that to happen. It would seem equity markets aren’t pricing in a slowdown at all, so there’s going to be a different response to future market events across asset classes; bonds and equities will not rally at the same time.

In these times of uncertainty, we look for businesses and sectors with good long-term profitability and cash-flow generation. Businesses with solid fundamentals are still going to be resilient in the long term, even if they jump around a bit in the short term. We are looking for pockets of unloved growth, good valuations and broad diversification across asset classes. In our view, cash, and gold for inflation protection are important too.

Patience is a significant strategic advantage and a key requirement for successful long-term investment. Short-term volatility evaporates, leaving no trace of the turmoil, except in the extremes where volatility mixed with high leverage can be strategy – and career - ending. We try to filter out the noise and daily news which can distort the bigger picture. It can be hard to stay patient when you’re being bombarded by alarming headlines, but it’s crucial to remove these distractions and stick to your long-term plan.

Capital Generation Partners LLP (“CapGen”) is authorised and regulated by the Financial Conduct Authority and is registered as an Investment Adviser by the US Securities and Exchange Commission. All information and opinions expressed in this article are subject to change without notice and CapGen and its affiliates do not warrant or guarantee its accuracy, reliability or completeness. Nor does this article constitute investment advice, an offer, contract or other solicitation to purchase any assets or investment solutions, or a recommendation to buy or sell any particular asset, security, strategy or investment product. The information contained in this article does not constitute research or recommendations from CapGen and please note that the value of any investments referred to in this article and their income may go down as well as up. Independent advice should be sought where appropriate and no liability is accepted, or responsibility assumed, in respect of persons who are not clients of CapGen, unless expressly agreed in writing. Advice is given and services are supplied by CapGen on the basis of our terms and conditions of business, which are available upon request.