Active investment commentary & analysis

Why investors should prepare themselves in the face of potential volatility

Should investors worry about current headlines; shortages, China, taxes and inflation?  In less optimistic times, any single one of these would have rattled the stockmarket.  Recently, bad news has simply been shrugged off.  Optimism is understandable; most trading updates from companies have been positive, typically reporting an exceptional rebound.  That could change rapidly, if central banks fail to act to control inflation, or if bond and currency markets really begin to question the power of those banks.  More volatility in markets may lie ahead; investors should prepare themselves and their portfolios.

A little inflation is no bad thing, allowing some readjustment in the economy.  Rising energy prices may even help to address climate change.  And - initially at least - companies find that higher prices usually mean bigger profits.  Shares have performed well over the past year, even though bond and fixed interest prices are now weakening.

But a dislocated economy with real shortages is something different.  It might have taken the petrol pumps to bring home this problem, but missing microchips are shutting down a lot of other activities, as are staff shortages.  Investors need to think about the impact on the profitability of the current shortage of key staff.  It is likely also to cut the dynamism of the UK economy, making it harder to establish new businesses.  Many activities are running below normal capacity despite the short term boost of higher prices.  These disruptions may be the precursor to profit warnings and economic slowdown.

Added to the economic uncertainty will be its impact on politics.  China faces a sharp slowdown that could disappoint a population that has for decades been motivated by a vision of increasing prosperity.  Economic weakness could even undermine China’s ambitions to regional leadership.  And China’s political system is particularly opaque.  What looked initially like a clampdown on internet activity and Bitcoin, seems to be escalating rapidly into a new model for the country.  China may not have been a big factor in previous market sell-offs, but is now too big a part of the global economy to ignore.  As the recent debt crisis within China’s Evergrande Group showed, it is also now quite deeply interconnected with Western investors.

Even in the UK, the government is being forced to change tack; responding on climate change and equality.  Some of this intervention will impose costs on companies and more generally higher taxes on consumers. Tax rises themselves are likely to cool the economy a little, but have rarely been the trigger for any sell-off in shares.  Unless, that is, tax policy on capital gains and inheritance changes materially.  Changes in these areas and the consequent impact on markets has been historically hard to predict.

There is potential for surprise.  What is clear is that tax policy enjoys less consensus than usual, and the UK government must make some unpalatable moves.  Higher tax on dividends is the first one investors will notice next year.

Historically, faced with such uncertainty, investors have simply raised cash.  This might be understandable in the current environment, when inflation has created asset bubbles in so many areas.  There is danger also in an overheated property market, and most international equity markets face similar challenges.  Cash has other problems; timing of re-entry is always difficult and investors quickly feel a sense of regret if they sell before the peak.

Instead, the best investor precaution may not be running for cash, but the psychological preparation of clearly understanding the role that a portfolio is playing in overall long term financial planning.  Rather than the choice being between selling early or amidst a stockmarket panic, good preparation can allow investments to ride through a storm without investor fear.  The pandemic has meant that many of those in jobs and working from home have accumulated greater savings during the lockdown.  This and strong stockmarkets have lured investors into bigger shareholdings.  Investors should think now whether the size of shareholdings is right for the medium and longer term.

A version of this article was published in The Herald on 02.10.2021.