How we guard your capital against macroeconomic and geopolitical shocks

By Dr David Allen
18 January 2024

Anticipating macroeconomic turning points and geopolitical events is notoriously challenging. Nevertheless, fund managers and the talking heads on TV are never backwards in coming forward with bold predictions.

Joe Gallagher at Morgans wrote a sobering note last week on how almost all the consensus narratives were wrong in 2023. Joe has kindly allowed me to reproduce that list here.

  • Mortgage Cliff? Wrong
  • Tech valuations depressed from rising rates: Wrong
  • House price collapse on Australia’s east coast: Wrong
  • China to invade Taiwan: Wrong
  • Banking contagion after multiple regional US banks collapse: Wrong
  • Energy crisis in Europe: Wrong
  • Inflation will remain high for a long time: Wrong
  • Lithium is the best commodity as there is no downside case for EV adoption: Wrong

One could add an expected hard landing in the US and a resurgent Chinese economy to the list.

It would seem experience is not always an inoculation against ropey forecasts.

Below we show the aggregate forecast earnings of the ASX 300 index in the three years up until each annual reporting season.

From 2010 to 2020, analysts were over-optimistic in ten out of eleven years inclusive. On average earnings were expected to be a staggering 35% higher than where they ended up. Then, emerging from COVID in 2021 to 2023, analysts were excessively pessimistic three years in a row, underestimating earnings by an average of 15%.

Source: Plato Investment Management, 2024Source: Plato Investment Management, 2024

In fairness, the inability to predict important events is not reserved for investors, analysts, and economists. Here is a list of the seismic events that the CIA, with near unlimited resources, failed to foresee.

The collapse of the Soviet Union (1991): The longstanding Cold War dynamic likely contributed to the failure to contemplate the rapid unravelling that followed.  

9/11 attacks (2001): Despite several intelligence leads, the CIA failed to anticipate the horrific attacks in the United States.

Weapons of Mass Destruction in Iraq (2003): The war was predicated on the widespread consensus in the intelligence community that Iraq had WMDs. No WMDs were ever found.

Collapse of the Afghan Government (2021): The CIA completely underestimated how rapidly the US-backed government would collapse leading to a hasty evacuation.

Russian invasion of Ukraine (2022): The U.S. intelligence community believed that Russia would quickly conquer Ukraine, failing to appreciate the resilience of the Ukrainian people and the impact of systemic corruption on the Russian military complex.

Hamas’ plan to attack Israel (2023): Despite extensive data sharing between the CIA and Mossad, the CIA was blindsided by the attack.

Anticipating shifts in technology is similarly fraught.

“I think there is a world market for maybe five computers” – Thomas Watson, chairman of IBM, 1943

“Heavier than air flying machines are impossible” Lord Kelvin, President of the Royal Society, 1876

“The telephone has too many shortcomings to be seriously considered as a means of communication” – Western Union internal memo, 1876.

“There’s no chance that the iPhone is going to get any significant market share. No chance” – Steve Ballmer, Microsoft CEO, 2007

So, as we enter a new year in a world where it is exceedingly difficult to anticipate macro and geopolitical crises, I thought it suitable to highlight the core process we implement to manage risk and protect your capital.

Protect, don’t predict.

While it’s clear no one can always anticipate the next shock, you can attempt to ensure portfolios will not suffer excessive declines when shocks inevitably occur.

Sure, this does take some prognostication.

The Plato team is continually applying macro and geopolitical stress events to our portfolio construction framework.

This means considering scenarios that could impact stock markets (not predicting when or even if they’ll happen at all) and ensuring our downside exposure to these events is limited.

This happens both on the long and short side of the Plato Global Alpha Fund portfolio.

Currently, 32 macro and geopolitical stress events are on our radar. These range from a shock to Chinese property to Lithium prices, from Inflationary expectations, to US high yield credit.

The next step involves identifying companies that would experience outsized impacts should these events take place.

For example, here are the ten companies we estimate that will be most adversely affected by a 30% crash in the ASX 300 (one of our current 32 stress events). Despite liking a couple of these companies, we do not hold any of them in Plato Global Alpha because of the extreme downside risk we perceive in the event of a market crash.

Now, to illustrate how this is implemented when assessing short positions, consider another of our current stress events – a 200bps fall in 10 year treasuries.

We are fundamentally bearish on most of the following highly rate sensitive names and would ordinarily be short several of them, however with the likelihood of rate cuts over the following twelve months, we are keeping our powder dry.

Winston Churchill is often credited with saying:

I always avoid prophesying beforehand because it is much better to prophesy after the event has already taken place

Churchill’s thinking is certainly appropriate when it comes to investing in stock markets.

We are not claiming the Plato Global Alpha Fund portfolio is bullet-proof – there are many unknowns. Who really knows what will be dominating headlines in world news this time next year?

However, we believe our disciplined stress events process provides our investors a metaphorical flak jacket in a world of significant uncertainty.

And finally, I would like to add our focus on risk management has not impeded our ability to generate strong returns, with the Plato Global Alpha fund delivering a 32.3% return after fees over the last twelve months.

Discover Plato’s range of investment opportunities: https://plato.com.au/strategies/

DISCLAIMER:

This document is prepared by Plato Investment Management Limited ABN 77 120 730 136, AFSL 504616 (‘Plato’). Pinnacle Funds Services Limited ABN 29 082 494 362, AFSL 238371 (‘PFSL’) is the product issuer of Plato Funds. Product Disclosure Statement (‘PDS’) are available at https://plato.com.au/. Any potential investor should consider the relevant PDS before deciding whether to acquire, or continue to hold units in, a fund. The Product Disclosure Statements (‘PDS’) and Target Market Determinations (‘TMD’) of Plato Fund is available at https://plato.com.au/. Pinnacle Fund Services Limited is not licensed to provide financial product advice.

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Past performance is for illustrative purposes only and is not indicative of future performance. Stock commentary is illustrative only and not a recommendation to buy, hold or sell any security.

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“A good decision is based on knowledge and not on numbers.”

Plato (427-347 BC)