There is an old joke about a tourist, trying to get to Dublin, who stops in a village out in the sticks to ask a local for directions. After a long consideration, the local replies ‘If I was you, I wouldn’t start from here’.
This neatly sums up what the paradoxical theory of change is about. All of us typically have a tough challenge on our hands reaching a ‘destination’ – whether this be in our personal or professional lives – particularly if, to begin with, we are not quite sure of our starting point.
More broadly, the paradox of change refers to the tension between the desire for change and the resistance to it that often exists within individuals and systems. It highlights the inherent conflict between the need for stability and familiarity, and the necessity for progress and adaptation. On an individual level, people may desire change and recognise its benefits, such as personal growth or improved circumstances. However, they may also feel comfortable with their current situation and fear the unknown or the potential risks associated with change. This internal conflict can create resistance to change, even when it is objectively beneficial.
Similarly, on a larger scale, organisations and societies can also face this paradox. They may acknowledge the need for innovation, adaptation or addressing societal issues. Yet they may be resistant to change due to factors like bureaucratic structures, vested interests, fear of disruption or a preference for maintaining the status quo.
Can this paradox apply to the world of investing?
Yes, clearly it can.
As we know, financial markets are complex systems, constantly evolving and subject to change due to a wide range of factors. These include macroeconomic conditions, technological advancements, regulatory changes, investor sentiment and geopolitical developments. In this context, the paradox of change can manifest itself through the fear of uncertainty, which can create anxiety and impact market behaviour. In times of significant change, such as economic downturns or geopolitical shifts – sound familiar? - investors become more cautious, leading to increased volatility and risk aversion.
Moreover, market participants traditionally grapple with the ongoing tension between variations to the norm and something which might be a significant step change. While established models and frameworks provide stability and familiarity, they may also hinder the recognition and adaptation to new market dynamics.
When we say ‘market participants’, we tend to think firstly of human asset managers, exhibiting the usual set of rational and irrational behaviours, which shape market sentiment and drive price action over the near term. As we know, however, more and more investment decisions are being driven by algorithms and machines, which could go some way to explaining why market performance through this first half of the year has baffled many. More on this later.
Reflections on these last six months
Referring to our opening comments and looking ahead to H2 2023, it is extremely challenging for money managers to set a course for asset allocation and portfolio positioning without understanding where they have come from and what their starting point is now.
Equity markets defied expectations in the first half of the year. Taking the S&P 500 as a proxy, the index notched up double-digit returns, even as inflation remained elevated and the Fed continued its fastest rate-hiking campaign since the 1980s. The big picture masks some nuances as this chart illustrates; technology stocks, after suffering through 2022, have carried index returns. Equally noteworthy, comparing the index’s market-weighted (c.17%) and equal-weighted (c.6%) returns, illustrates just how much a handful of mega-cap stocks ― primarily tech-related across IT (Nvidia, Microsoft), telecom services (Alphabet and Meta) and consumer discretionary sectors (Apple, Tesla, Amazon) ― have driven year-to-date performance. Since making a low in mid-October 2022, the S&P 500 has rallied 21% ― bull market territory. During this period, let’s not forget these returns were delivered against a backdrop featuring a ‘mini banking crisis’, the arrest of a former president (and would-be candidate in 2024), ongoing fears of a US recession, the gating of large real estate funds, China’s lacklustre reopening and further interest rate increases from major central banks.
Market behaviour has seemingly reverted to the norm of the last decade, as if ignoring the fundamental shift in financial and economic conditions which – and we include ourselves in this – most investors had repositioned portfolios to anticipate.
So, what is our starting point? – consider the Yin and the Yang
We retain the view that we have seen a significant regime shift to an investment environment featuring higher inflation, rates and volatility compared to the 2010s ‘QE forever’ era. We believe this backdrop is likely to involve a much wider dispersion of potential outcomes and returns from one quarter to the next. We have arrived at this conclusion by looking at the opposite but interconnected forces at play; the Yin and the Yang.
Geopolitics will continue to impact markets; negatively, looking through the lens of the conflict in Ukraine, but positively – perhaps – if viewed through the lens of the recent peace breaking out between Iran and Saudi Arabia. Fears of energy shortages in Europe through the winter proved too pessimistic, whilst expectations for large productivity gains from the rollout of artificial intelligence might prove overly optimistic – at least in the near term. Interest rates look set to rise further and though there are clear signs inflation is falling in developed economies, we suspect it will remain uncomfortably higher than target. On a more positive note, inflation is lower in developing countries, leaving central bankers with room to cut rates to boost their domestic economies. The US dollar, on most valuation metrics, is overvalued and the Japanese yen, using the same set of metrics, is too cheap. Finally, global growth – surprisingly stronger than forecast to-date – could falter if, monetary policy, which has taken longer than expected to take effect, now begins to bite, while China’s economic performance continues to underwhelm.
The most telling indicator of this contrasting and contradictory set of market dynamics can be found in the pricing of volatility. Since last October, the Vix index, which measures the one-month implied volatility of the S&P 500 – and is derived from the equity index options market – has trended steadily lower, to levels indicating complacency. In contrast, the Move index, which measures the one-month implied volatility of US treasury notes and bonds, has remained elevated. As a result, the two indices have diverged in a way the market has not seen since early 2008. We will all remember what happened later that year when equity market volatility played catch-up.
Implications for portfolios
Investment managers are used to operating in an environment where decision-making is based on an assessment of probabilities; in other words, they can never be quite sure. Today, tried and tested frameworks, models and scenario analyses are painting a confusing picture, given the range of inputs we have described. Additionally, the explosive growth of AI-linked allocations now influencing capital flows leads many to suspect financial market behaviour has changed forever, making some of the techniques and routines employed by the industry less effective. Time will tell, but we are on the page AI capabilities will enhance the ability to manage money, and we are exploring the many tools and opportunities being created.
The world is changing at geopolitical, macroeconomic and societal levels at a rate we have not seen before. Change has been ever-present throughout history; however, technological advancements are amplifying this significantly. We believe the most sensible approach to managing assets currently is to combine prudent participation with thoughtful diversification. We need to carry investments which can deliver performance in a range of different market conditions, while incorporating diversifiers – strategies with uncorrelated return streams – which can provide some downside protection when times are challenging.
Rising rates, stubborn inflation, mounting public debts, bank failures, war in Europe… and the best first half for the Nasdaq in 40 years. Now there’s a paradox.
Sources: BlackRock Taking Stock; Q3 2023, Equity Marketing Outlook. Gavekal; What's next for the S&P500
