The economic clock continues to tick. The Bank of England has warned of a 1 in 3 chance of a Brexit recession as uncertainty continues to loom. Further afield, the risks to the global economy, with heightened international trade tensions and signs of slowing growth have led the US central bank, the Federal Reserve, to cut interest rates for the first time since 2008. What's more, we are 10 years into a global economic expansion – now the longest on record.
the most of the opportunities that uncertain markets bring.
Now is not the time to focus only on upside opportunities. The hour is late in the economic cycle and the risks in these uncertain times are considerable.
When change is constant, what are the risks?
From the dismal last quarter of 2018 to now has been a rollercoaster. We have gone from markets pricing in a global recession by this time in 2019; to a significant six month rally across asset classes, helped by monetary policy easing and the prospect of a US-China trade deal; to fears that the world's two largest economies are readying for something much worse than a simple trade war.
Neither side looks likely to yield until they get what they want or something gives. For the US, stock markets seem to be the pain point; for China, it's the broader economy and access to global markets.
Our concern is thavt this scrap could be more dangerous than many people have assumed. It may mark the beginning of a drawn-out de-globalisation of the global economy and its intricate value chains.
In any case, the current situation might get nastier before it gets better. We may need a reaction from markets and an impact to growth before either side capitulates. We deem this reason enough to be adding robust defence to portfolios.
Implication for portfolio positioning
We are naturally defensive and believe we have added to our portfolio fortifications. But we remain cautiously optimistic and, in our view, uncertainty is creating inconsistent pricing.
Now the Fed has cut interest rates, bonds could revert to being more negatively correlated to equities (which they weren't last year). This makes them a more useful diversifier within portfolios. You could offset higher equity exposure by adding duration in markets where yields are relatively attractive and where interest rates could be cut still further in future (e.g. US Treasuries).
Options remain attractively priced, implying that investors see little risk of negative outcomes in the future, which is what options insure against. Cheap insurance means it can be cost-effective to use options to participate in market upside (if there is any) while protecting against potential downside. At present, an investor might build a case that equities could gain 20% in a year, or that they could lose 35%-40%; options are a good way of playing such an uncertain environment at relatively low cost.
Let's not forget how late in the cycle we are. Historically, equity markets peak about six to nine months ahead of a recession.
Even if a recession is not imminent, it is prudent to manage a portfolio to withstand a range of risk events with the potential to transpire over the coming year.
We were put to the test recently in May when equities fell to -6.2%, which was the fifteenth worst monthly performance for equities over the last 15 years (October and December 2018 were the thirteenth and eleventh worst months for equities.)1 During these conditions, the defence we added proved a shrewd investment as we avoided this downturn and outperformed the market by some margin.
Similarly, during the last risk-off period in the last quarter of 2018, we reduced the portfolio's sensitivity to tighter monetary policy and reduced exposure in the 'melt-up' euphoria early in the year.
Uncertainty remains high as we move through 2019. We continue to actively manage the risk within the portfolio by focusing on our best ideas at the security level, aiming to capture the opportunities that the market still presents. Given our risk and return objectives, we believe the overall mix of exposures is well diversified by sensitivity to the economic cycle, so everything should not go up or down at the same time; exposure to known risks such as the uncertainty around the US-China trade war is limited; and we are actively managing the risk behaviour of the portfolio to changing market conditions.
The clock keeps ticking.
We intend to remain steadfastly vigilant, even if everything else keeps changing.
- Source: Investec Asset Management and Bloomberg.
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