Quick Thoughts: The Dangers Of Inertia

By Stephen H. Dover, CFA, Chief Market Strategist and Head of Franklin Templeton Institute, Franklin Templeton

What does the concept of inertia have to do with portfolio allocations? Head of Franklin Templeton Institute Stephen Dover explains.

Originally published in Stephen Dover’s LinkedIn Newsletter Global Market Perspectives.

Investors often try to explain the behavior of capital markets through the lens of natural science. If Newton’s Laws of Motion were repurposed into Laws of Investing, we would understand investors “going with the trend” as creating more inertia, increasing the resistance to a change in direction.

Newton’s Second Law of Investing would then tell us that the momentum of the price trajectory continues moving in the same direction – unless acted upon by a force.

The “second law” is critical: the more inertia, the stronger the force needed to change the direction of the momentum. However, once there is a driving force present, such as the directional force caused by higher interest rates or the random forces of greater economic uncertainty, the trajectory of momentum will inevitably change.

When it comes to the merits of a balanced portfolio, investors may find themselves caught up in the inertia of the masses, with most asset classes suffering negative returns in 2022.

While equity and fixed markets have broadly rebounded to start 2023, this does not necessarily mean that traditionally diversified portfolios will now deliver on their promise.

With the consensus of economists’ forecasts and key market indicators pointing to recession, difficult negotiations to lift the debt ceiling ahead in the United States, and war in Ukraine dragging on, uncertainty continues to dominate the landscape.

Diversification still matters

We begin with a key point of emphasis – now is not the time for investors to give up on the diversification benefits of holding balanced portfolios, those comprised of stocks, bonds and other asset classes.

The extreme outcomes of last year, characterized by large, simultaneous losses on all major asset classes, were an anomaly stemming from unexpectedly high inflation and aggressive monetary policy tightening.

In my view, those developments have now largely run their course and, as a result, cross-asset correlations are likely to normalize to historical averages, producing the benefits of diversification.

Specifically, the advent of accelerating inflation last year undermined returns across stocks and bonds. Bond yields had to rise to compensate investors in real terms for rising prices.

They also had to rise to reflect rapid hikes in short-term interest rates as central banks tightened monetary policies. The result was sharp declines in the prices of government, corporate, and high-yield bonds, and emerging market assets.

Higher interest rates and greater economic uncertainty also eroded the future value of corporate profits, leading to a compression of stock market valuations.

Even though profit growth remained positive last year, falling valuations meant that returns slumped deeply into negative territory. Unexpected inflation always leads to significant setbacks in portfolio returns and, in that sense, 2022 played out exactly as one would have expected.

But today, as inflation recedes, bonds are bouncing back. Long-term interest rates have fallen nearly a full percentage point from last year’s highest levels, producing positive returns for their holders.

Those gains have helped to offset still-mixed performance in US equities, and in the process, offering diversification in balanced portfolios. I believe those diversification benefits, moreover, are likely to endure as inflation continues to fall and as central banks eventually confirm expectations for a pause in rate hikes.

Moreover, should economies dip into recession, safer long-dated government bonds and high-quality corporate bonds should provide an important ballast against earnings disappointments for equity markets.

In short, while the temptation to give up on diversification is understandable after the wretched performances of stocks and bonds last year, that would be a mistake today. There is probably no better time to be diversified than the present.

Why now?

The appeal of balanced also reflects an observation I made at the beginning, namely that financial market indicators – such as the yield curve – as well as the consensus of economists, expect a US recession in 2023. And even if an economic recession can be avoided, a profits recession is already underway.

According to FactSet, which compiles and analyzes corporate profits, Wall Street analysts anticipate S&P 500 Index corporate profits will fall in the current earnings season (i.e., for the fourth quarter of 2022). Moreover, those same analysts expect negative year-over-year profits growth for the first half of 2023.¹

The problem is several-fold. First, most firms are facing higher costs for almost everything – wages, energy, raw materials, transportation, and business services. Despite increasing their own prices over the past year, most are seeing costs rise faster than revenues. As FactSet also notes, S&P 500 Index corporate profit margins have been declining for the past 18 months.

Second, growth is beginning to slow, primarily because of tighter monetary policy. Higher interest rates are taking their toll on interest-sensitive sectors of the economy, including housing, commercial construction, capital expenditures and big-ticket consumer items. Given fixed costs, slowing sales increases average total costs, resulting in a further compression of profitability.

Third, as firms see their profits squeezed, they begin to cut their expenditures. Hiring is slowing and layoff announcements are increasing. Discretionary purchases are being canceled or cut back.

That is one reason why previously high-flying information technology companies are in the spotlight. Search and social media companies are, essentially, advertising platforms and when times get tough, companies slash advertising budgets. Software services and outsourcing of sales services are other candidates for the chopping block.

Looking specifically at the United States, the implications across sectors are clear. Large capitalization growth stocks dominate major equity indexes, and these companies are now at the leading edge of the earnings recession.

Last year, their poor performance was owed to rising interest rates, which eroded their valuations. This year, their poor performance stems from profits disappointments.

Balanced plus

Investors content to access equity markets through so-called “passive” indexes that reflect broad market capitalization are likely to see below-average (perhaps even negative) returns in 2023 because they are (passively) over-exposed to those parts of the market where earnings disappointments are likely to be most acute.

The answer, however, is not to shun equities. Rather, it is to think more actively about where positive returns are more likely.

One possibility is China or, more generally, in equities that benefit from China’s reopening. In the first weeks of 2023, that story is already in plain sight, with equity indexes in mainland China and Hong Kong outperforming the S&P 500 Index.

Why China? The answer is macroeconomic momentum. After a disastrous policy of extended and harsh lockdowns, the Chinese government capitulated to COVID-19 late last year, announcing a reopening of the economy. Tragically and yet predictably, infections have skyrocketed, as have deaths (it did not help that vaccination rates are low in China, particularly among the elderly).

Yet, for all the human suffering that COVID-19 is presently inflicting on China, infections will soon run their course. Accordingly, economic reopening will proceed. And, just as was witnessed in North America or Europe, reopening will result in a burst of economic activity as pent-up demand is unleashed and productive capacity enhanced. Moreover, unlike any other major economy in the world, China is actively promoting growth via easier credit and fiscal policies.

After barely growing in 2022 (officially real gross domestic product grew 3.0%, but the actual rate of growth was probably less), China’s economy is expected to register growth above 5% in 2023.²

What that means is that in a world otherwise characterized by slowing growth and flagging corporate profits, China is an outlier, providing more of both. And it isn’t just China, it is all the economies and companies that do business with China, spanning much of East Asia and Western Europe.

Conclusions

There are two conclusions I would suggest to investors: diversify and be active. Falling inflation should restore the importance of balance between stocks and bonds in portfolios. And a smarter form of balance is called for.

Sticking with past winners is a recipe for disappointment. I think it makes sense to look for where growth and earnings are likely to surprise to the upside.

And in 2023, many signs are pointing towards China and those economies that benefit from China’s recovery. Fight inertia as the forces looking to shift the trajectory of the economy and capital markets are gaining momentum.

What are the risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.

The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. This is not a complete analysis of every material fact regarding any industry, security or investment and should not be viewed as an investment recommendation. This is intended to provide insight into the portfolio selection and research process. Factual statements are taken from sources considered reliable but have not been independently verified for completeness or accuracy. These opinions may not be relied upon as investment advice or as an offer for any particular security.

1. Source: FactSet, “S&P 500 earnings season update,” 20 January 2023.

2. Source: ”China GDP: IMF says 5.2 percent economic growth possible this year after Covid-battered 2022” South China Morning Post, January 2023. There is no assurance that any estimate, forecast or projection will be realized.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.