Insight - Making Sense of the Narrative

As we get to half year we see narratives shifting - the negativity on equities is fading after a strong recovery which is feeding into more positive views on economics, although this is only consistent with the new New Normal view that we had in January. The narrow breadth of the rally however has led to AI as a new narrative that we feel is over-done. Equally, while geo-politics has died down as an issue, the Geo-political related weakness in China equities is being 'explained' by an economic narrative that also doesn't really add up. Bonds meanwhile are caught between long term buyers looking to lock in a real return in a 2-4% inflation world and traders who have flipped from Pivot to tighten and who are focusing once again on high frequency data. Q3 is generally lower volume, but potentially higher volatility

The behavioural biases discussed in Daniel Kahneman's 2011 classic Thinking Fast and Slow are central to Market Thinking and our efforts to not only understand the biases in other investors, but to control them in ourselves, We have now created a system that allows us to reduce our own unforced errors, while recognising them in others in order to understand better 'the narrative'. These tools are now being used in a newly launched UCITS fund bringing together Market Thinking and highly regarded alternatives manager Toscafund.

UK Inflation is driven by essentials like Food, energy and Housing - the cost of living crisis. The BoE's policy appears to be to raise 'taxes' in the form of higher mortgage costs to 'tame' this inflation. The only way this will work is to completely collapse demand for everything else. Crucially, the orthodoxy ignores the impact interest rates have on supply, rather than demand - lower rates increase supply and lower inflation, higher rates do the opposite. Bond vigilantes think this policy will support their market (which is why they are demanding 'credibility'.) Far more likely is stagflation, which is bad for everyone.

The recent squeeze in Mega Cap tech is actually part of a recent series of gyrations between Tech and Energy that was stimulated by the arrival of huge flows into ESG and has been exaggerated by front running both their inflows and the flows around momentum investing strategies that have been rebalancing

Our own experience confirms that most of the problems facing active fund managers are structural to the industry, ironically largely a result of risk management processes that limit the ability to vary benchmark risk according to market conditions. The model portfolios we discuss here on Market Thinking have been built over the last three years to explicitly avoid these issues and look to take the appropriate level of risk in both high conviction and low conviction markets - our definition of conviction being the scores we create as part of our market thinking process at the portfolio component level. As more than 2/3rds of the time we are in such markets, we see this as a key part of generating long term returns while having lower volatility and downside risk.

To out-perfrom a market, you need to take different risks than the market. The problem is that most active managers are institutionally prevented from doing so.

Including this year to date, Chinese Equities are down for the third year in a row, while Japanese Equities are up for the fourth year in five. Covid, Geopolitics, and Index weightings for diversification are all part of the story, but we also think that just as western models that assumed low interest rates would cause inflation singularly failed to recognise their role in a savings based culture as return on savings on the downside, so they are also missing the point that higher rates will generate higher demand and inflation in Japan

A note recently published on livewire about how AI rather than the Fed will bring down the cost of education and healthcare - and thus inflation.

The biggest challenges for markets are from cash - having been too cheap to borrow and too expensive to save, we now have the opposite, with some balance sheets under pressure while liquidity is syphoned out of equities and credit by high deposit rates. Market breadth is extremely narrow, with 493 stocks flat ytd and 7 up more than 50%. Much of this is tied into hype around AI.

Markets are largely range bound, albeit the previous strong correlations have broken so that some are at the top of recent ranges while others are at the bottom. This is contributing to an overall feeling of uncertainty, compounded by lack of direction from central banks, Geo Politics and muddied economic data.

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