Britain’s most bearish investors name their fears

In his most famous speech, former US Secretary of Defense Donald Rumsfeld laid out a neat analysis of risk. 

For him, there were “known knowns” - things we know we know – but also known unknowns - things we know we do not know. 

Finally, there were unknown unknowns – things we don’t know we don’t know. 

This may be a useful framework to examine some of the potential pitfalls in global stock markets today. 

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Fund managers with a focus on protecting investor capital need to understand a range of potential risks and hedge against them. 

These include naturally cautious investment trusts such as Ruffer Investment Company (LSE:RICA), Capital Gearing Ord (LSE:CGT) and Personal Assets Ord (LSE:PNL), but also global equity income and multi-manager funds. 

Their managers are focusing on a range of knowns and unknowns in the current environment.

The big beast

The risk that most investors are focused on is artificial intelligence (AI) – a “known known”.

Everyone understands that markets have become excessively concentrated, and dependent on the AI investment cycle, but they are hoping that AI will be as revolutionary as promised.

Jasmine Yeo, fund manager at Ruffer says: “If confidence in the returns on that spending starts to fade, the risk is a valuation shock, particularly in the areas of the market where optimism is most concentrated.

“A broader vulnerability lies in the scale of AI-related investment, which has become an important support for the US economy. 

“Spending on data centres, semiconductors, power infrastructure and related technologies is helping to underpin capex, confidence and corporate earnings. 

“If that cycle disappoints, the risk is not just a derating of AI-exposed equities, but a broader growth shock as one of the economy’s strongest engines begins to slow.”

This is undoubtedly a risk, but it is a risk of which everyone is aware, and that everyone is watching.

Other concerns

Robin Black, a co-manager on the Aegon Global Equity Income GBP B Acc (BF5SVX3) fund, says: “Concerns of an AI bubble are very topical, but they dominate a disproportionate amount of the risk debate at a time when there are a wide range of concerns to consider.”

The potential for an inflationary shock is real and Black’s view is that this could present at least as great a risk as an unwinding of the AI trade.

“A barrel of Brent oil now costs close to $90 as the Strait of Hormuz effectively remain closed, driving input costs for companies higher,” he says. “If these costs are not passed on to consumers, margins will decline.” 

This will weigh on share prices. 

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AI is also a contributory factor to inflation. 

As Yeo puts it: “The capex cycle could continue to stimulate demand in an economy that is already proving resilient. That would keep growth firm, support risk appetite and make it harder for inflation to fall back towards target.”

She points out that it’s already proving difficult to keep inflation under control. 

US inflation has been above the Federal Reserve’s 2% target for more than five years, suggesting the system has a clear inflationary bias. 

“Rather than acting as a ceiling, the target increasingly looks like a floor.” 

Policymakers can’t blame it on temporary factors such as the war in Iran. In the last set of inflation data, energy costs dropped 1.5%, with shelter costs contributing most to price rises. 

The indomitable foe

And Iran is still a looming risk. 

Charlotte Yonge, co-manager on the Personal Assets Trust, believes this may still be underestimated. 

“Iran is an indomitable foe, prepared and able to suffer economically for a cause.  The low cost of rendering the Strait unpassable gives it a strong hand.

“The oil price has remained relatively quiescent thanks to countries, particularly China, running down reserves.  This, however, is changing.” 

The Personal Assets portfolio is seeking to protect against these risks with inflation-linked bonds and gold.

A fragmented world

Iran has been a contributor to inflationary pressures, but it is also a symptom of a fracturing global world order. 

This is another major known unknown for global stock markets. 

Deglobalisation has been a phenomenon since Covid, and arguably even longer, as geopolitical tensions, resource nationalism and re-shoring have forced companies to question the wisdom of lengthy supply chains, even if it means cheaper input costs. They have proved fragile and insecure. 

For Yonge, the instability of global supply chains is a source of concern: “The closure of the Strait of Hormuz is the most recent symptom of a world that is deglobalising and becoming more unstable in the process.  

“The pandemic and Russia’s invasion of Ukraine both served to accelerate the pace at which countries are seeking to reshore manufacturing capabilities and secure energy domestically.  

“Tariffs and now the war in the Middle East increase the urgency.  We think this spells a rockier time for global prices and for bond yields.” 

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Climate change is also affecting supply chains in unpredictable ways. 

Since early August, for example, low water levels in the Rhine have started to disrupt barge transport. 

Reuters reports that chemical producers, utilities, steelmakers and agricultural traders have warned of higher ​costs, transport bottlenecks and curbed production. 

Yonge also points to the “Super El-Nino”, which is likely to exacerbate pressure on harvests towards the end of this year.  These are curveballs for companies and the global economy. 

Also in the realm of known unknowns are the forces at work in the currency markets and whether they could create disruption for global financial markets. 

For Chris Clothier, co-chief investment officer at CG Asset Management, the US’ recent intervention in yen markets exposed some underlying nervousness on the part of US policymakers. 

“It is very rare for one country to intervene in another country’s currency. This reflects the deep unease that the US has at present.”

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However, US central bankers face a catch-22.  

On the one hand, Clothier says, a weak yen makes Japanese exporters more competitive relative to American producers. 

“However, the most reliable way Japan has to strengthen its currency would be to increase interest rates. 

“They have already come a long way: Japanese 30-year government bond yields are currently around 3.95% and, barring briefly topping 4% in May and July, are at their highest levels ever recorded.  

“Japan is the largest foreign holder of US Treasuries. 

“If Japanese interest rates rise much further, Japanese institutions will be tempted to sell their foreign holdings and buy Japanese government bonds. 

“This could cause US government bond yields to rise dramatically, creating problems in an already febrile US Treasury market.”

That might not be a problem were debt not so astonishingly high. 

For Adam Norris, co-portfolio manager on the CT Global Managed Portfolio Trust, this is the risk that underpins everything. 

“Debt to GDP in the UK, eurozone and US has now ballooned to 94%, 89% and 120% respectively – debt which is now being refinanced at higher interest rates than the 2010-2020 period.

“Meanwhile, fiscal spending shows little sign of slowing, with competing demands on government budgets from defence requirements, healthcare (from ageing populations), subsidies to alleviate energy price shocks and an electorate increasingly accustomed to larger welfare payments.”

Taxes have already risen and there are no guarantees that bond investors will continue to fund the fiscal holes, he says. 

If they baulk, and the so-called bond vigilantes suddenly demand even higher interest payments on government debt, then bond yields could rise with knock-on effects for government, corporate and consumer borrowing costs. Markets are unlikely to weather a bond market rout. 

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This could be bad for stock markets, but David Roberts, head of fixed income at Nedgroup, says it could be an opportunity for bond holders. 

“Bond yields are high. They are higher than most of today’s fund managers, fund selectors and general investors will remember,” he says. 

“They are as high as they have been since the global financial crisis, 18 years ago.

“The biggest risk? Investors ignore the opportunity and miss the best potential bond market returns this side of the millennium.”

To throw in more known unknowns, Black points to demographics, the erosion of central bank and judicial independence in the US, fiscal or monetary policy error and protectionist policies.

As for the unknown unknowns, it is difficult to speculate – rogue AI, climate disaster or simply the next White House initiative. It is an environment designed to keep investors on their toes.