The arrival of the ‘post peak’ market environment has made old models of portfolio diversification outdated, according to GAM Investments’ Larry Hatheway, who said investors need to change how they think about diversifying their portfolios.
The emergence of a ‘post peak’ environment during the second half of 2018, the GAM group chief economist said, has been characterised by slowing growth and is also likely to define 2019.
While markets have begun to adapt to the new environment, the adjustment is not yet complete.
“Confidence has been shaken and will not be easily restored,” said Hatheway. “Even when the bottom occurs, we believe a decade-long era of investment outperformance, characterised by above-average returns in stocks, bonds and credit accompanied by mostly below-average market volatility, is over.
“The bull market in bonds ended in mid-2016. In our view, the middle of 2018 marks a similar end to the best of the equity bull market.”
As such, investors will have to become used to lower returns and “more jagged market performance”, according to the economist, who warned that volatility will recur with greater frequency.
“The reason is simple,” he said. “In a slower growth world, the margin for error is smaller.
“Yet the probability for error – trade conflict, a messy Brexit divorce, policy irresponsibility, geopolitical risk – does not seem to be receding.”
As a result, investors need to shift to “effective portfolio diversification”, according to Hatheway.
Performance of 60/40 MSCI AC World/Bloomberg Barclays Global Aggregate index YTD
Source: FE Analytics
“In common parlance, the balanced 60/40 portfolio is no longer fit for purpose,” he said. “Returns are lower, volatility higher and correlation less stable.
“Portfolio construction must shift to one of selective equity risk, based on exposure to companies with reliable earnings and business models – but not ‘value’ – coupled with uncorrelated exposures to specialty credit and non-directional strategies.”
One potential issue that markets seem to be pricing-in at the end of 2018 is a risk of recession next year, although according to Hatheway those concerns may be overdone.
The GAM economist said the sharp sell-offs in equity markets that started in October “have yet to find a convincing bottom”.
Since the end of September, the MSCI World has fallen by 9.51 per cent in sterling terms due to ongoing concerns over a US/China trade war and the pace of the Federal Reserve’s rate-hiking regime, as the below chart shows.
Performance of index since October 2018
Source: FE Analytics
“In December, equity market weakness was joined by strong rallies in duration fixed income and a further flattening of the US yield curve, suggesting that investors see an increased probability of a significant global economic slowdown, if not recession,” said the economist.
However, while there are significant challenges for markets – particularly around issues such as trade war, Brexit and other geopolitical issues – concerns over the economic outlook are overdone, said Hatheway.
“As a consequence, we believe even a relatively benign macroeconomic backdrop in 2019 will probably be accompanied by recurrent episodes of volatility,” he added.
“Jagged market price action, higher volatility and a greater dispersion of returns put the emphasis squarely on proper portfolio construction and risk control.”
The flattening of the US Treasury yield curve, which has almost inverted, and the de-rating of global equities have sparked concerns for a 2019 recession.
However, Hatheway said market signals maybe overstating the risk of a downturn.
“It is commonly and accurately cited that an inverted yield curve has preceded every US post-war recession,” explained the GAM chief economist. “However, the leads and lags can be long and variable.”
Hatheway said there have been a number of factors behind the increase in demand for US Treasuries, such changes in foreign central bank policy stances and risk preference leading to a “structural increase in demand for the risk-free asset”.
“All things equal, as the Fed lifts short rates, we believe the yield curve will flatten sooner and more than in previous cycles,” he said.
There is also evidence – most notably in the UK – that the government bond yield curve can invert many times with little cyclical predictive power, according to Hatheway. When it has foreshadowed a recession, the economist said there have been other factors at work such as wide credit spreads and positive and rising real interest rates.
“That is not the case now,” he said. “The US high yield spread over Treasuries today is roughly two-thirds its average level in the run-up to the last three US recessions.
“The current real Fed Funds rate is barely positive, in contrast to an average level of two percentage points – or higher – prior to the last eight US recessions. Even the latest decline in the US S&P 500 index only takes it back to the levels seen in Q2 2018.
“In short, the yield curve may be tipping into ‘recession’ territory, but financial restraint is not significant.”
As such, the economist said most leading indicators do not point to anything “remotely recession like”, highlighting high employment levels, rising household income and “boom-like” manufacturing numbers.
While recession fears may be overdone, investors should not relax, said Hatheway, adding that there remains concerns over a potential corporate earnings disappointment.
“In the US, 2019 earnings will face challenging base comparisons, following more than 20 per cent profits growth this year,” he explained. “Earnings are also a leveraged play on the business cycle, so softer activity will drag down profits growth.”
Finally, there is also the threat of mounting cost pressures, the latest quarterly reporting season revealed, with wages, interest and energy expenses affecting margins.