Commentators speak about a “Something Must Be Done” approach to politics, where any action is deemed better than no action. Behavioral economists warn of a similar bias among investors, the need to tinker in ways that often end up eroding returns. In difficult environments like today’s, such biases can become irresistible.
From the standpoint of our Asset Allocation Committee, however, a dispassionate look at the global economy and markets leads to low levels of conviction. Large directional bets amongst broad asset classes, on a 6-18 month horizon, are mostly off the table for now. Global growth is uninspiring; central banks seem to have lost their ability to influence markets; political risks loom; and high levels of financial market volatility seem at odds with mostly benign fundamental economic data.
Positive results from policy moves now appear to have built-in limitations. Should the dollar rise too much, it will likely curtail U.S. corporate earnings and suppress the wider economy. Should corporate earnings and wages take off, Fed Chair Janet Yellen will likely raise rates and undermine confidence in market liquidity. There is somewhat of a guardrail around a neutral position that could limit the payoff for risk taking, and the time the market takes to second-guess these limitations gets shorter and shorter. The Bank of Japan’s move to negative rates was good news for 24 hours, but then sparked a big bout of market volatility. Last Thursday’s changes to ECB monetary policy pushed the euro down and risk markets up, before a few words in the press conference unleashed a quick reversal.
Against that background, on a 12-month horizon our Asset Allocation Committee is, not surprisingly, neutral on U.S. equity, neutral on emerging market equity, neutral on emerging market debt, neutral on inflation-protected Treasuries and neutral on commodities. Our only biases at the moment are slight overweights in non-U.S. developed market equities and high yield bonds and underweights in government and investment-grade bonds.
That’s good. The Committee is resisting the bias to action. But then again, there is a view that something should be done. And here’s the interesting thing: Underneath the disciplined neutrality at the asset class level there is a lot going on.
The S&P 500 Index ended 2015 almost exactly where it started. Today it is not far from that same level. Similarly, commodity prices and credit markets are back where they were at the start of 2016. It doesn’t feel that way, though. Recent months have witnessed some of the most vicious market rotations of the past five years.
In other words, while taking medium-term, high-conviction directional positions in asset classes has become very difficult for asset allocators, there are widespread opportunities for individual underlying investment category managers, adding value through shorter-term trading or relative-value positions (which also tend to be more tactical). In our view, positioning within asset classes may be more beneficial than positioning between them. There is also value in thinking about your portfolio as a collection of individual positions with different time horizons, as well as a collection of different asset classes.
Within fixed income, some opportunities are easier to identify: You can buy higher-yielding bonds and companies with decent credit positions and sell lower (or indeed negative) yielding sovereign debt. In currencies, everything is a relative value position by default, so this can be a robust source of added value in these environments. In equities, there are some extreme valuations out there if you look in the right places: The cumulative outperformance of momentum stocks over value stocks is higher than at any time since the dot-com bubble, for example, and we believe that relationship will eventually begin reverting to the mean.
Having said that, short-term volatility does still create opportunity at the asset class level. In this environment, you could well boost positions in risky assets more broadly when markets sell off, but perhaps on a hedged basis through long/short strategies, paying away some of the asset-class exposure in exchange for limited downside. Visibility may be low, but opportunity needn’t be.
From all of this, three principles stand out. Active management becomes crucial. Incorporating alternative sources of compensated risk—value versus momentum, liquidity and volatility plays, spread trades—becomes an important tool in the toolbox. And risk management is paramount when you include these more tactical sources of excess return potential in portfolios.
What would make us comfortable favoring more directional risk? A breakdown in the correlation between oil and stock markets; a bottom for commodity prices; stabilization for some of the fundamental data points coming out of China; improved U.S. corporate earnings; and less reliance on negative interest rate policy from central banks.
Given the current mixed signals from the global economy, markets and policymakers, the full toolbox in multi-asset investing is likely to be useful for a good while yet.
Neuberger Berman’s CIO insight