If recent market volatility has taught us anything, it is the danger of focusing on hope over reality.
I cannot, for example, recall a corporate results announcement that was as eagerly anticipated as Nvidia’s at the end of August, when investors responded to an ostensibly positive set of results by wiping more than $200bn off Nvidia’s market value.
This provided a perfect example of the danger that the ‘reality gap’ – the gap between what we hope will happen and what is likely to actually happen – can pose to investors.
The reality is that Nvidia is a high-quality company at the cutting edge of a technology that could revolutionise our lives and it is growing at a spectacular rate. However, this lofty ambition simply wasn’t enough to meet the hopes of investors, analysts, traders and gamblers. We have got used to Nvidia smashing expectations and it didn’t. The share price fell as a result.
While short-term volatility does, of course, subside, there are trends which have emerged recently that can help investors extrapolate how markets will behave for the remainder of the year.
For example, interest rate expectations are top of mind for most investors at the moment. The reality is that inflation appears to be under control globally and rates have now fallen in the US, UK, European Union and many other countries. Predicting what happens next, however, is where things get more complicated.
The Federal Reserve will almost certainly cut rates further throughout the remainder of the year and more so next year, notwithstanding its bumper 50 basis points cut in September. But by how much and at what speed? This is where it’s essential for investors to pay attention to the gap between what we hope will happen, and how events will actually play out.
Investors hoping for rates to rapidly fall back to low levels over the next few months, and constructing their portfolios accordingly, need to be alert to the possibility that they will be disappointed.
In July, we sold out of Nvidia in our Diversified fund range because we understand that hopes can be dashed, and frequently are. It doesn’t mean it’s a bad company, we just didn’t feel it would meet the enormous expectations the market had set for it.
It will be the same if US rates don’t fall as quickly as expected, or indeed if they fall faster than expected, which would prompt fears about the strength of the US economy. Bonds, equities, gold, Bitcoin and most other asset classes will react.
So, what does the reality gap mean for asset allocation?
Firstly, we remain positive on equities, particularly medium and smaller companies globally. While equities undoubtedly look expensive relative to history, they are by no means extraordinarily overpriced, outside of the mega-cap US technology companies, which leaves less scope for downside surprises.
We also like the UK over the long term. The economic picture looks positive and we are consistently finding many exciting companies to invest in. But our home market is where the reality gap can be widest and it’s critical that hopes for the future performance of the UK do not cloud our understanding of the fundamental outlook for UK assets.
As we look ahead to the Autumn Budget, for example, we are paying close attention to the new government’s fiscal agenda. The government’s commitment to fiscal prudence is to be welcomed, particularly given how the mini budget in September 2022 affected the international perception of UK assets.
But we are also cognisant of the impact that tax rises might have upon the strength of UK consumers and by extension upon the health of UK companies and the broader economy. The backdrop is not conducive to attracting international and domestic or corporate and institutional buyers back to the UK equity market just yet. We remain confident, however, that value will out.
Despite this, our overall market outlook for the next three to five years is almost as positive as it has ever been and we feel there are attractive long-term returns on offer for investors within most asset classes.
For example, we continue to see great value property companies across the UK and Europe, and this is a sector where we expect to see a strong recovery over the medium term as rates come down. The returns available from sections of the bond market also provide a solid bedrock to our portfolio.
While there are reasons to be optimistic right now, things remain unclear in the short term, with volatility likely throughout the remainder of the year. If anything, the events of the past few months should bring home the fact that it is always worthwhile preparing to be disappointed.
Neil Birrell is lead manager of the Premier Miton Diversified fund range. The views expressed above should not be taken as investment advice.