Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Last month’s sell-off was mainly a reaction to macroeconomic headwinds that have been building this year; recent and expected corporate earnings growth has not weakened much. A handful of earnings disappointments by highly valued and high-profile tech firms have spurred vicious sell-offs, but these have been outliers. Building macro concerns and a few downbeat earnings calls translated into an approximately $3.6 trillion October decline in equity market values.
With an aging economic and market cycle, high US equity valuations, and central banks gradually withdrawing liquidity, markets may become increasingly sensitive to modest changes in expectations. Investors should ensure that their portfolios incorporate sufficient liquidity, as well as diverse sources of risk and return (global equities, bonds or cash, real assets, and strategies that are not correlated with the above).
What are investors seeing as they wander the dance floor after midnight? The central bankers are starting to leave the party, punch bowls in hand. (Meanwhile, rising rates are muscling their way in, carrying a strong US dollar on their shoulders.) This development is rarely a good one. Rising rates boost the cost of debt for corporations and households, and debt attracts flows from equities as yields become more compelling. Furthermore, dollar strength negatively impacts emerging markets via several channels including debt affordability, commodity pricing, and policy rates.
Global growth has been looking healthy, but recent data in China and Europe betray softness and some divergence across emerging and developed markets. The US economy is humming along, goosed by the corporate tax cuts. However, Brussels is butting heads with Italy’s new populist mashup of a government, which aims to simultaneously pacify the left-wing 5 Star contingent with spending and the right-wing League voters with tax cuts. The combo is a budget-buster, forcing a November showdown with the European Commission. The uncertainty surrounding Brexit appears likely to extend for years. Inflation (via sterling depreciation) and depressed growth are the result.
But the global political disputes today aren’t just between neighbors. The imposition of tariffs on hundreds of billions of dollars in China-US trade is boosting prices across a host of goods, which could crimp demand or impact margins. The Chinese government is also warily trying to constrain debt growth, and that combo is weighing on the Chinese economy, which now accounts for nearly one-sixth of global growth.
How might investors ensure that their portfolios are resilient in the face of volatility? Given space constraints, I will mention only three suggestions here:
- First, investors underweight richly priced US equities should be careful not to decrease USD exposure (which tends to be defensive). US-based investors can hedge the residual exposure to non-USD currencies that arises from the US equity underweight (currency-hedged equity ETFs might be helpful). Conversely, an investor that spends in euros or pounds might decrease currency hedge ratios to ensure neutral USD exposure.*
- Second, exposure to growth via an illiquid form (such as a buyout, venture capital, or growth equity fund) must be accompanied by a robust return premium in exchange for tying up capital for many years. Private funds have been quite valuable in boosting portfolio returns, but when making future commitments, evaluate whether the manager’s competitive advantage in deal flow and operational enhancement is sustainable.
- My third piece of advice is relevant for investors considering exposure to growth via long/short or long-biased equity hedge funds. It is difficult to find fundamental managers with short-term investment horizons that maintain durable advantages over their quantitative competitors and that can withstand drawdowns without being forced to close and return capital. Investor commitments to such funds should be very selective. As an alternative, investors that have not already incorporated trend-following into their portfolios might consider doing so, despite less-than-thrilling recent returns. Tested over decades, trend-following is not harnessed to equity markets, and it benefits from information dispersion and ingrained behavioral tendencies.
* Please see the fourth quarter 2018 edition of VantagePoint, published October 17, 2018.
Sean McLaughlin, Head of Cambridge Associates’ Capital Markets Research