As we moved into 2018, our view was simple: The ‘goldilocks’ economic environment that had driven most markets higher, in some cases to record levels, in 2017 would soon come to an end.
With further monetary policy normalisation and growing inflationary pressure on the horizon, we felt that there was not only a greater risk of a policy ‘mistake’ or a ‘communication error’ from a major central bank, but moreover we also anticipated more frequent market stress events.
As such, our primary focus at the turn of the year was to position ourselves to manage risk in its entirety: macro risks in the context of less synchronised global growth, market risks in the form of correlation shocks, and political risks against the backdrop of a potential ‘trade war’ and global geopolitical tension.
This type of dynamic, risk managed and cautious investment strategy proved successful in navigating the VIX burst in February, as we were able to deliver positive and smooth returns over what was a tricky quarter for many investors.
Although we have seen equity markets recover and implied volatility recede since the blowout, we still believe that investors will finally have to say ‘goodbye to Goldilocks’ and ‘hello to Volatility’ by the end of 2018.
Importantly, investors now have to make a difficult decision about where to go from here. Even though the current market context may seem stable on the surface, underneath it is far less clear and more dispersed.
While we believe that the risk of recession remains low, the dispersion of growth expectations across the globe is something investors should take note of. We do not expect this to mean that growth-oriented assets will deliver negative returns, but we do think it is an ‘amber’ light that could justify a lower exposure to such areas of the market.
On the inflation side, pressure is growing with capacity utilisation and labour markets tightening further. To address this, investors could look to lower their exposure to sovereign bonds in favour of real assets such as breakeven inflation rates, which are still below central bank targets, and cyclical commodities. A tactical underweight in duration can be, however, a costly approach due to the ‘negative carry’ on the position, alongside the risk of a ‘flight-to-quality’ as risk aversion remains high amongst market participants.
In the equities space, for example, the MSCI AC World Index is essentially flat year-to-date, illustrating how cautious investors have remained since February’s correction. Moreover, while US equities are positive over the year, others such as the emerging and Swiss markets are lagging behind.
That said, have equities reached levels low enough for investors to enter the market with full force again? We think that both retail and institutional investors will continue to ‘err on the side of caution’ for the rest of the year. There are still concerns around a global ‘trade war’ borne out of the Trump Administration’s policy agenda, and the rising uncertainty surrounding European political unity as illustrated by the recent events in Italy.
What is particularly interesting in the current market context is that a lot of what we are seeing is driven more by sentiment, rather than by fundamentals. Sentiment is inherently more difficult to assess and monitor because it can change quickly and can be led by different elements, some more rational than others.
Timing and calibration within an investor’s portfolio will also be essential to navigate the periods of future volatility we see ahead, particularly when investors are having to turn more ‘defensive’.
Implementing a defensive strategy too early, or with hedges too large, can destroy the carry of an investor’s strategic allocation, whereas doing it too late means you may no longer have anything left to protect.
In terms of calibration, we believe in the diversification of hedges. We like using FX, optional strategies and the VIX to protect portfolios against a market stress event and an equity downturn. We are currently more optimistic about the US economy than we are for the rest of the world. Therefore, with a hefty arsenal of hedges against various risk factors, we are comfortable retaining an overweight in developed equities in our tactical portfolio. We believe that the projected rebound in macro indicators in the second half of this year will turn momentum positive again mainly in US.
To successfully navigate through the potentially choppy markets ahead, it will be critical that investors, both European and those on the other side of the pond, view risk beyond standard metrics. We believe that risk is multi-dimensional, and it should be viewed in terms of the potential loss of capital rather than being proxied by an oversimplified or abstract measure, such as volatility or correlation.
Guilhem Savry (pictured) is head of Macro and Dynamic Allocation and portfolio manager on Unigestion’s Multi Asset Navigator fund.