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More broadly, markets can be categorised as being ‘risk-on’ or ‘risk-off’. The assets which perform in these two scenarios are very different. So, in this week’s article I discuss:

· The difference between risk-on and risk-off environments

· The assets that perform in each regime

· The current market environment

I hope you enjoy the article, and as always, let me know your thoughts by emailing thesparknewsletter@gmail.com

Risk-on vs Risk-off

Generally speaking, markets swing like a pendulum from risk-on to risk-off. Risk-on environments occur when investors feel good about the economic outlook. Money is easy and flowing smoothly through the system, GDP (the economy) is growing, unemployment is falling or low, and there is little uncertainty. Below you will see a quadrant, with the right-hand side conveying a risk-on environment and the assets that perform well. The top right reflects an inflationary boom, and the bottom right reflects a disinflationary boom. Assets are also colour-coded, from the lowest volatility (cash) to the highest volatility (emerging markets – more on this in my next article).

Conversely, the left-hand side of the quadrant classifies risk-off environments, with the top left being stagflation and the bottom left being deflation (recession). Risk-off environments come when there is high uncertainty, investors are panicking, and markets are volatile (and potentially declining sharply).

This quadrant is a simple way to decide where we are in the business cycle on a macroeconomic level and helps me allocate capital in a systematic way. As an investor, systematising your investment process is essential as it removes a lot of our emotional tendencies from investment decisions – Fear of Missing Out (FOMO) and recency bias being the main two. Trading and investing on emotions will cost you.

Applying the Quadrant

Applying this quadrant over the last two years shows just how well this works. In Q4 of 2019, we entered a manufacturing recession in the USA (ISM Manufacturing PMIs were contracting– see below), and the yield curve briefing inverted. This was a tell-tail sign for investors to get defensive. Growth was slowing globally, and inflation was nowhere to be seen – meaning we were in the bottom left of the quadrant. Markets went into risk-off mode in March as COVID rampaged through the world. During this period, investors were extremely fearful, uncertainty and volatility were high, and markets were plummeting. Getting defensive in October 2019 would have meant you missed the last 14% rise in the market, but you also missed the 40% drop in March 2020.

***US Manufacturing PMIs went into contraction (below 50) at the end of 2019, Source: TradingView***

Once the authorities stepped in, things took a sharp turn for the better. Central banks cut interest rates to 0% and bought billions of dollars of bonds, and governments guaranteed defaults on bank loans. Investors soon realised that the money created and distributed in the form of ‘stimmy’ cheques and loans would help protect the populations (consumers) pocket and prevent business bankruptcy, so risk-on was back. Remember that markets are forward-looking, so by April/May 2020 as authorities stepped in to backstop the economic contraction, we moved swiftly to the bottom right of the quadrant as the market expected accelerating growth to come (as inflation was still non-existent) – the perfect environment for stocks. This would have led you to sell your bonds and deploy cash into equities.

Through the remainder of 2020 and into Q3 2021, equities boomed with little volatility (see below - S&P 500 trading in a tight channel throughout 2020/21). We moved from the bottom right to the top right in 2021 as inflation continued to rise, and commodity producers outperformed tech stocks (which still did reasonably well). Money was everywhere… until it wasn’t.

***S&P 500 traded in a tight range throughout 2020/21 (blue channel), Source: TradingView***

Back to Deflation

Loyal readers of The Spark know I have held a significant cash position (above 15%) since November 2021. Around this time, market internals were deteriorating. What I was waiting for has now arrived – and we are officially back in a risk-off environment. From November 2021 until now, we have swung between the top right (inflation) and top left (stagflation) of the quadrant. The unexpected war in Ukraine stoked inflation further and contributed to a continued boom in commodity stocks (top right), but high energy prices are causing growth to slow in the UK and Europe. The Bank of England has already warned of a 10% inflation rate and a potential recession by the end of this year, meaning we are officially entering stagflation territory. For this reason, I have become increasingly worried about the strength of the consumers’ spending habits over the remainder of the year, so reduced exposure to consumer discretionary stocks in The Spark’s portfolio through the sale of Dave & Buster Entertainment (PLAY).

The prospects of sticky inflation and therefore a more aggressive stance by the Federal Reserve (Fed) are affecting financial markets drastically. Investors have become increasingly worried about this stickiness, and so have been pricing in an increasing terminal interest rate – the highest interest rate investors predict the Fed will hike to - since January 2022. One major reason markets have been falling lately is because interest rate rises have become increasingly ‘front-loaded’ i.e. investors expect the majority of the rate hikes to come sooner rather than later, and this is what is damaging both stocks and bonds today.

Looking at this week’s US CPI (inflation) reading, it seems that inflation may have peaked. This month’s reading came in at 8.3%, below last month’s 8.5% reading. This looks like a positive sign, but if we look under the hood, inflation is moving from commodities (as oil prices have stabilised) to the stickier service sector. Inflation could remain higher for longer, and therefore the Fed cannot change its aggressive stance. This is an important inflection point because if inflation doesn’t come down substantially this year, financial markets will continue to drop lower, as investors aren’t currently pricing in abnormally high inflation (and therefore a terminal rate above 3%).

Just because it has fallen, doesn’t mean its cheap

““With these higher expectations placed on many companies (through their higher valuations) there is likely to be greater execution risk and therefore even more casualties in earnings season 2022 Q1 compared to Q4 2021 … hence why I am avoiding such companies at current valuations.””

— End of Year Review

As mentioned in my end-of-year review (above), I expected Q1 2022 earnings season (when companies report their profits) to be tough, but that would be an understatement. Earnings have been a bloodbath, with many companies missing revenue/earnings estimates and downgrading forward guidance for 2022, especially in the technology sector. Valuation metrics and free cash flow matter today more than ever. As you can see below, higher inflation rates kill technology/growth stocks because they are predicted to be profitable far out in the future. Therefore, the market is now applying a higher discount to these profits/cashflows, and such stocks are being repriced to the downside.

***Higher inflation means companies devalue future revenue and cash flow***

Looking around today, many growth stocks have fallen in excess of 80% but still seem overvalued – examples include Shopify (SHOP), Plug Power (PLUG), and Snowflake (SNOW). In my opinion, such companies could fall another 80% before they reach fair value.

The End of the Road

I am comforted by the fact that many famous investors have been vocal about the difficulty of predicting market movements today. Asset correlations that have been reliable over recent years have broken during 2022. Emerging markets should fall in a risk-off environment like today - hence why I halved my position in Airtel Africa - but in many cases have not. The Japanese Yen (to my detriment) was a safe haven in years gone by but has been far from that in 2022. Bonds were a hedge when equities fell but now both bonds and equities are falling in unison. I cannot stress the importance of this last point enough (more below). Today there are few places for investors to hide.

Globalisation will likely go into reverse over the next decade, as western nations’ over-reliance on China and global supply chains has proven costly over the past two years. This will be inflationary, meaning the 60/40 portfolios (60% of capital in stocks and 40% in bonds) days may be outnumbered.

Traditionally, and as suggested by the quadrant above, bonds offered protection when stocks fell. The negative correlation between these two assets has benefitted 60/40 or risk parity portfolio over the past 40 years, but this correlation has broken as inflation worries have persisted, and central banks began to tighten policy.

***Risk Parity has not got off to a good start - down 19% since November 2021, Source: TradingView - RPAR***

Bonds are now selling off alongside equities (they now have a positive correlation), which means many 60/40 portfolios have ZERO downside protection. Unless inflation subsides, this will continue. This break in correlation is partially what has caused the market sell-off this year, as the fall in bonds caused contagion selling and de-grossing by institutions. De-grossing is a process where large institutions (hedge funds etc) sell positions indiscriminately as market volatility rises, in order to reduce their overall risk. This causes a vicious cycle of selling upon selling.

Demand is Rolling Over

Initially, I believed markets had overpriced the economic slowdown, hence why I added companies such as PayPal to the portfolio (small positions thankfully). However, I have been proved wrong in this view and it seems we are heading for a recession in Europe. Growth is slowing substantially, with demand for imports falling in China (the world’s largest commodity importer) and data points such as the Philadelphia Fed’s new orders predicting slowing demand in the second half of this year. With many commodity miners falling substantially on earnings, and Dr. Copper (the copper price – see below) alongside other industrial metals rolling over, it seems I have bought the top in commodities. Unless Chinese demand picks up substantially to meet the rising inventory levels, commodities have found a top. The stock market may be front-running the economy into this slowdown or recession (much like 1921). For these reasons, I have decided to sell my position in Anglo American (AAL).

***Dr. Copper is rolling over, Source: TradingView***

Action:

Selling 100% of Anglo American (LSE: AAL) at £34.50 for an 8% loss (-£21.92)

***Portfolio Return Year-To-Date: 0.8% vs S&P500: -16%***
***Total Return since inception (20/09/21): 6.7% vs S&P500: -7.7%***

Summary

***Jeff Bezos on Amazon’s stock price during the 2000 Dotcom bubble crash***

Know what you own.
Don’t overtrade in a bear market.

I remain patient with cash in hand.

Until next time,

Peter

Disclaimer

This communication is for informational and educational purposes only and should not be taken nor used as investment advice, as a personal recommendation, or solicitation to buy or sell any financial instrument. This material has been prepared without considering any particular recipient’s investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past or future performance of a financial instrument, index or structured product are not, and should not be taken as, a reliable indicator of future performance. I assume no liability as to the accuracy or completeness of the content of this publication.