The market setbacks at the end of last year marked an end to a decade of strong stock and bond returns, accompanied by low volatility. In just the first three weeks of December of last year, the MSCI World Equity Index plunged over 13%. Even a so-called “balanced portfolio”, comprised of a 60-40 market-capitalization weighted allocation to stocks and bonds, lost more than 7% in the same period.
Welcome to “post-peak”, a world of decelerating economic and earnings growth, as well as heightened political and policy risk. For investors, the implication is a prolonged period of poorer risk-adjusted returns. Investment management must adapt.
We believe US and European investors are only now realizing what “post-peak” means. In emerging markets, including in Asia, the story is hardly new. Over the past five years, emerging equities have been on a roller coaster, with steep losses in 2015 and 2018 that book-ended strong performance in 2016-2017.
What is driving this change?
Global economic growth is slowing. So, too, is corporate profits growth. Recent GDP downgrades by the European Commission, the Reserve Bank of Australia and other official institutions merely confirm what markets already knew. The lustre is coming off the euphoria of a synchronous global expansion.
No major economic region is being spared. In the US, the housing and autos markets have slowed. In 2019, the receding benefit of the 2017 tax cuts and fears of trade conflict may both be sources of weakness. In our view, Europe, Italy and even Germany are on the brink of recession. Matters could get worse if the UK tumbles out of the EU without an agreement. In China, credit tightening slowed fixed asset investment last year just as trade conflict sapped exports and production.
Perhaps most worrisome is that, with the exception of China, slowing global growth is difficult to pin on monetary or fiscal policy. Despite the Fed’s interest rate hikes, real interest rates are not at restrictive levels. US fiscal policy has been very expansive. European monetary policy hasn’t even begun to tighten.
We believe that’s troublesome for several reasons. First, if policy is not the cause of the slowdown, then counter-cyclical policy moves may not be particularly effective either. Second, fiscal policy tools are constrained. The US has little financial latitude to cut taxes or increase spending, and is anyway hamstrung by divided government. Germany has latitude but no will to be anyone’s locomotive, not even its own. The UK is in political disarray over Brexit. China may provide some stimulus, but it fears that credit easing will create even larger misallocations of resources than already exist.
Policy makers everywhere could try to restore “animal spirits” damaged by trade conflict and political disarray. But policy orthodoxy, particularly on trade, appears more elusive than ever.
It is also worth noting that slowing growth coincides with signs that costs are rising, as wage growth picks up and productivity stagnates. Profit growth is therefore also post-peak.
The implications for investment management are profound. Mere market exposure is likely to produce disappointment—index tracking has lost its appeal. Investors must adopt strategies that minimize drawdowns. After all, if returns are lower, it will take longer to make up for losses. Tactical asset allocation must be deployed with greater flexibility as well as an asymmetric approach to loss minimization. Small deviations from benchmarks won’t cut it when markets are in free-fall.
Above all, more careful attention must be paid to cross-asset correlation and volatility when managing portfolios. Balanced portfolios of stocks and bonds are ill-equipped if they cannot deliver diversified returns and avoid large losses. Non-directional strategies, such as relative value, alternative risk premia and other liquid alternatives, should play more important roles in multi-asset portfolios. Composites of relative value positions across currencies, commodities, equities, corporate and government bonds—often referred to as target return strategies—offer uncorrelated returns alongside select equity and fixed income holdings.
These strategies should garner a significant share of the strategic asset allocation. Our research suggests that, together with cash, non-directional strategies warrant a third or more of total portfolio weights in order to generate proper diversification.
In our view, the US and Europe now join Asia in “post-peak” investment environment. The onus now shifts from merely being invested to being properly diversified. All investors, regardless of how they invest, will need to make the right kinds of active portfolio construction decisions if they are to navigate the post-peak environment effectively.
Larry Hatheway, group head of GAM Investment Solutions