Our take on the medium term outlook

In September 2007, customers of Northern Rock bank were given a very simple message: “don’t panic.” What followed was, at the time, one of the largest bank runs in history. Sometimes the very words meant to prevent panic are the ones that cause it.

Like many lessons, this is one I learned the hard way. I can remember, (though I am too scared to re-listen to the recording) giving a similar “don’t panic” message in 2022 on a radio show as inflation was accelerating globally and in New Zealand. A caller dialed in and expressed his opposing view in fairly direct terms. As it turned out, we were both right, just over different time horizons.

That experience has stayed with me. Not simply because the call was uncomfortable, but because it reinforced something simple: context is more useful than reassurance.

So rather than focusing on the developments between the US and Iran, where we don't have any advantage in terms of predicting what happens next, we think that putting context around what is happening right now is a far more useful focus point.

Here are a few things which we believe are relevant in contextualising markets right now.

1. Inflation shocks are harder to insure for than growth shocks

In the decade or so following the Global Financial Crisis, the 60/40 portfolio (a mix of bonds and equities) worked a treat. Market shocks were typically due to growth shocks, which led to falling bond yields and therefore bonds did a decent job of offsetting equity losses. This alongside the NZ dollar, which tends to sell-off during periods of global stress, has provided meaningful offsets to falling markets.

The issue with inflation shocks is that bonds don’t typically provide any offset over the shorter term as the market's response to inflation is typically higher interest rates rates (also called yields). I say "short term", as higher bond yields ultimately results in higher long term expected returns in absolute terms.

There are very few places to hide in inflationary environments. One asset class in the past which has delivered strongly is commodities, which was one of the few asset classes to deliver positive returns in 2022, a year when global equities (hedged) fell some 18%.  

This latest bout of volatility has seen strong performance from broad commodity indices which invest in a range of collateralised commodity futures, though not all the futures, such as gold, have delivered. 2. Equities have double digit draw-downs (falls) in most years

Against this backdrop, it’s also worth grounding expectations around what ‘normal’ volatility looks like.

When I talk to most people about returns last year, they are happy. After all indices like the S&P 500 were up 17.9%, while the MSCI All Country World Index which aims to capture global stocks, was up significantly more than that. It is amazing how we forget about the chaos that followed “Liberation Day” which saw shares in the US fall, peak to trough, some 18.9%! Interestingly, a fall of that magnitude isn’t uncommon during any given 1 year period. In fact, since 1950, the average intra-year peak to trough fall is 13.6%, yet this hasn’t stopped the S&P 500 delivering a handsome 11.7% annualised return over this full period.

In other words, the current drawdown (fall) in equity values is not atypical of what we commonly see in markets. 3. Average returns are not typical returns

Since 1928, when our data source begins, the return for US Equities has been around 10% per annum. Further, the common return forecast for equities from asset allocators, ourselves included, typically congregates between 6 – 8% on a forward-looking basis. Interestingly, since 1928, the annual return of the S&P 500 has returned between 0 – 10% only fourteen times. In other words, history tells us that 86% of the time the annual return for the S&P 500 is outside the range of 0 – 10%.

Source: S&P, Robert J Shiller 4. Entry points do matter

Valuations always matter - just not always immediately. One of the more reliable anchors we have is the Shiller CAPE ratio, which smooths earnings over a decade and has been shown to have real explanatory power for long-term returns. Put simply, the higher the starting valuation of the sharemarket as a whole, the lower the subsequent 10-year return has tended to be. That’s easy to ignore in strong markets, but history is pretty clear on what happens when you don’t. At the peak of Japan’s late-80s bubble, there were stories, probably apocryphal, but directionally right, that the land under the Imperial Palace in Tokyo was worth more than all the real estate in California. It captured the mood: prices had detached from reality. The Nikkei then spent more than three decades getting back to its 1989 high. The same dynamic played out in the tech bubble— the Nasdaq-100 peaked in 2000 and didn’t sustainably reclaim that level until the mid-2010s, implying a “lost decade” and then some once you adjust for inflation. These episodes are not anomalies—they’re the natural consequence of paying too much for assets upfront.

Where we can see this clearly in the gap between fund returns and investor returns. Time-weighted returns, what gets reported, measure the underlying performance of the assets. But dollar-weighted returns, what investors experience, tell a very different story, because they reflect when capital is put to work. Morningstar’s long-running “Mind the Gap” research shows that, on average, investors earn around 1–2% per annum less than the funds they invest in, largely due to poor timing of entry and exit. Put more bluntly, investors tend to buy after strong performance and sell after weak performance, exactly the opposite of what you would want.

There are few better real-time case studies of this than the ARK Innovation ETF. The fund itself delivered extraordinary returns in its early years, but the bulk of investor capital arrived in 2020–2021, right at the peak. As performance reversed, the average investor experience was dramatically worse than the headline numbers. In fact, dollar-weighted returns lagged reported returns by more than 25 percentage points over certain periods, and a large portion of investors remain underwater despite the fund’s earlier success.

We see this happening not only in markets, but also in the selection of managers currently, with investors rotating out of growth style equity funds and into value style funds. This of course is the investment style that has worked better in more recent times. This is the opposite of what we saw just five years earlier, as many value strategies were struggling, particularly in COVID times, so investors chased growth funds based on their past performance.

The below chart plots the Shiller CAPE, a valuation metric, and the forward ten year returns of the US market.

Source: S&P, Robert J Shiller. Chart shows relationship between high starting valuations and lower future returns.

Where we stand on the current market conditions

None of this is to say that the current environment is without risk, there clearly is. But history suggests that volatility, drawdowns, and dispersion in returns are features of markets, not bugs.

The more important question for investors is not what happens next week or next month, but how portfolios are positioned to navigate a range of outcomes from here.

In our view, maintaining diversification, being conscious of starting valuations, and avoiding reactive decision-making remain the most reliable anchors in an increasingly uncertain world. In our own portfolios, this means we are weary of relying too much on global equities as a source of returns and looking towards assets with different returns exposures such as select exposures within private markets and real assets.