Confessions of a portfolio manager - #2
When is news noise? Today, David confesses that knowledge is power, but admitting when you’re not the expert is key. He looks at the US-China trade war tensions as an example of how news can influence investment behaviour.
There is such a thing as too much information – knowledge is power, but knowing everything about everything isn’t necessarily a good thing. Admitting when you’re not the expert is key. Focus on what matters the most; and that is what fundamentally drives markets.
Noisy news – when to take it seriously, and when not to
In today’s digital world, stories travel fast – and straight to our fingertips. As such, our daily routines have become accustomed to being bombarded with news from across the world, and reacting to it. Some of it is simply noise and can serve to distract us, but some needs to be taken more seriously. A quote from Herbert A. Simon perfectly sums up the concept of noisy news:
‘ A wealth of information creates a poverty of attention...’
Herbert A. Simon
Indeed, it seems as though hardly a day goes by without another geopolitical event dominating our daily flow of information. The recent U.S. China trade war is a good case in point.
So, when situations like these arise i.e. situations that unfold quickly and have a wide variety of potential outcomes – but with outcomes that fall into the ‘difficult to predict’ camp – we need to ask ourselves: is this noise, or news?
Be candid and confess
The first thing to do is candidly confess: we are not political forecasters nor should we try to be. As such we don’t have any informational advantage when it comes to elections or political events. Our expertise and experience is in the fundamentals of markets. So, when situations like these arise, we tackle such conflicts using scenario analysis and focus on those outcomes.
How do we use news to influence our investment behaviour?
Value, Cycle and Sentiment
When we designed our investment process we settled on three building blocks: Value, Cycle and Sentiment, it is through this lens that we view the world. Our approach here is to measure the probability versus the impact. A high probability event with negligible impact can largely be set aside; but, an event with a significant potential impact (regardless of its probability) should be given due consideration.
Sentiment is the most obvious manifestation of such an event. As such, our sentiment scores will tell us whether the change in financial markets is abrupt enough to push investors into a state of euphoria or fear. However, because Sentiment is attuned to the market’s response to the event (as opposed to the event’s character), it does not answer why markets are moving. And therefore, it does not give us insight into whether the move is warranted or overdone. For that we need Cycle.
When we are confronted with a geopolitical event that is both meaningful and abrupt, we quickly zoom in on the question at hand: has our outlook for the Cycle changed? If the geopolitical event or risk is expected to change the course of the business cycle, then we want to reflect that in our thinking.
US-China tensions case study
On 22 March, President Trump announced tariffs on $50bn of imports from China under the Section 301 investigation into China's intellectual property policies. This has the potential to lead to restricted inbound Chinese investment in the US and restrictions on the export of US intellectual property to China, investigation is wide-ranging and its potential impact is larger than the steel tariffs. On 1st April China in response to the first round of US tariffs announced its own retaliatory tariffs on 128 US products including a 25% charge on pork and seamless steel pipes, A severe trade war is not our main case scenario at present as notably, the Chinese Ministry of Commerce noted that “...both sides should use dialogue and consultation to resolve their mutual concerns.”
However, it is important to be prepared for the case that current tensions could escalate. Using our Value, Cycle, Sentiment process, we explore how we might react in such a scenario below.
A trade war would be severe enough to disrupt supply chains broadly and significantly slow down economic growth albeit may not be severe enough to cause a recession immediately.
Under an escalating trade war scenario, we would cut our Cycle scores significantly. Equity cycle scores would drop the least for the US, more for the eurozone, Japan and UK and most for emerging markets. We would also downgrade Value for emerging markets due to structural damage to supply chains and profitability. Other risk assets would see similar Cycle downgrades. We would leave government bond Cycle scores unchanged. While inflation would go up under a trade war in the medium term, the inflation effect is offset by more dovish central banks – at least in the short term.
It should be noted that our Sentiment indicators would probably change as markets adjust to the reality of a trade war, but it is not possible to say how the Sentiment scores evolve and our model portfolio would also adjust to changes in Sentiment that cannot be captured by the scenario analysis we have presented here.
What would be our intended course of action under the trade war scenario?
Under the trade war scenario, we would tilt portfolios away from risky assets. This would likely mean reducing exposures to non-US regional equities, as we see US equities being less affected by a severe trade war. Positions in real assets like global listed infrastructure and global real estate would likely be cut, as would exposure to risk-seeking fixed income asset classes like high yield and emerging market debt. Overall this would likely see a move towards less risky assets, such as government bonds and investment grade credit. At the same time, it is possible that we would increase our exposure to cash. This wouldn’t be a dip we would buy into until value had significantly appeared to account for the change in the economic cycle.
To emphasise, the severe trade war outlined above is not our main case scenario. As such, we are not currently looking to make any changes to our global multi-asset multi-manager portfolios as a result of these trade developments. Financial markets are still supported by strong tailwinds in the form of a synchronised global economic expansion, strong US fiscal stimulus in 2018 and 2019 and healthy corporate profits.
We also think that the tariff measures announced by President Trump are partly aimed at shoring up support for the mid-term elections and appeasing his base. They could also be a negotiating tactic to extract concessions from Canada/Mexico in NAFTA talks and from China in bilateral trade negotiations. As such, there is likely to be a willingness to compromise and row back from the aggressive opening gambit.
China's ongoing reaction to the tariffs will be key. Thus far they have been as expected, relatively restrained, however the Whitehouse has reacted angrily fuelling speculation that the tariffs as related to Intellectual property due to be realised this week, might be stricter than first thought, and with China's ambassador to the US, Cui Tiankai, warning that Beijing would take counter-measures of "the same proportion", tensions are high.
Filter the noise by focusing on the consequences
The conclusion for us therefore is to focus on consequences of the event, this helps filter out the noise, and the "will they or won’t they" nature of the debate and refocus on the fundamentals where our degree of understanding is much clearer. But also on the starting valuation point which can dictate the magnitude of the consequences. Ultimately you can’t quality control the outcome but you can quality control the decision-making process. Structure and a clear process help us to separate the noise from the fundamentals.
Remember, it’s impossible to process the vast swathes of information that we are bombarded with daily. Focus on what you think drives markets, and do it in a regulated fashion.
Next time, David reveals his checkpoints for changing probabilities...
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