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Investment views

The clock is ticking

24 June 2019
Authors: John StopfordHead of Multi-Asset Income, Jason Borbora-SheenPortfolio Manager

The fast read
The economic clock continues to tick. The trade war is heating up again and common recession indicators are suggesting the countdown to a downturn has started. Investors need to think hard about adding defence to their portfolios so they can:

  • Make the most of the opportunities that uncertain markets bring
  • Insulate their portfolios from potential volatility
  • Avoid much of the drawdown in markets over rocky periods

This is what we have been focusing on, which saw the strength of a defensive approach in the last two major market drawdowns (May 2019 and ‘red October 2018’). Though past performance does not indicate future returns, we believe remaining steadfastly vigilant is best, even if everything else keeps changing.

Scroll to the bottom of the article for the podcast.

The economic clock continues to tick. The relief sparked by fiscal easing and a de-escalation of US-China trade tensions has faded. Now, the trade war is heating up again and the yield curve – a traditional recessionary gauge – has inverted, suggesting a downturn might happen within the next two years.

We are 10 years into a global economic expansion, which is close to a record. The equity bull market is of similar vintage. Draining dollar liquidity is pressuring some sectors and political risk is mounting. The recent European parliamentary elections highlighted the strains within the EU; the UK is in the midst of a conservative leadership battle; and the run up to the 2020 US elections is gathering pace.

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.

Investors need to think hard about adding defence to their portfolios.

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 record-breaking first quarter rally across asset classes helped by 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.

The last few weeks have seen negotiations sour faster than you can say “tariffs”.

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.

With tough talk on tariffs threatening economic growth and dragging down the Dow Jones Industrial Average, Washington’s approach seems in conflict with ‘market-man’ President Trump’s ideals. But this is no longer just a trade war. It is a battle for dominance with more at stake than the economy and stock prices. Increasingly, the US is framing its dispute with China in terms of national security, with intellectual property rights, technology and China’s involvement in early stage venture capital and M&A projects under scrutiny. Political concern over this issue is gathering momentum if the number of tweets is a gauge, highlighting that the narrative can turn on a dime. Trump has shown that he’s not just a market man, but a ‘tariff man’ as well:

“...I am a Tariff Man. When people or countries come in to raid the great wealth of our Nation, I want them to pay for the privilege of doing so. It will always be the best way to max out our economic power. We are right now taking in $billions in Tariffs. MAKE AMERICA RICH AGAIN [sic].”

President Donald Trump, Twitter, 4 December 2018

The focus of the tariffs mirrors the US electoral map. They are directed particularly at areas of relevance to the US farm states, where many votes could be won. With the US economy doing well so far this year, it is no surprise that Trump is pursuing a protectionist policy heading into 2020.

Our concern is that 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. Investors should be careful not to let seemingly positive data mask the risks arising from the lateness of the cycle, whose negative impact may take time to appear in asset prices. Even if the trade dispute is resolved, it would only be a short-term fix. De-globalisation is a long-term theme.

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

If investors prepare adequately, we believe they can make the most of the opportunities that uncertain markets bring.

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.

For example, we think that now the Fed has shifted away from tightening “whatever happens” to focusing much more on swings in data and financial conditions, bonds could potentially revert to being more negatively correlated to equities (which they weren’t last year). This makes them a more useful diversifier within portfolios. Hence, we believe that one could offset higher equity exposure by adding duration in markets where yields are relatively attractive and where interest rates could be cut in the 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 basically 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 reasonable 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.

Again, let’s not forget how late in the cycle we are. Historically, equity markets peak about six to nine months ahead of a recession.

If the crunch is 18 months away, you need to be thinking now about how to exit and the mix of assets you should hold to insulate a portfolio from potential volatility.

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 very 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.

We also responded to the rising recession risk as the year progressed, helping the portfolio to avoid much of the drawdown in markets over the period but especially during the last quarter of 2018.

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.

Listen to the podcast

1 Source: Investec Asset Management and Bloomberg.

Past performance is not a reliable indicator of future results, losses may be made. 

John Stopford
John Stopford Head of Multi-Asset Income
Jason Borbora-Sheen
Jason Borbora-Sheen Portfolio Manager

Important information

Past performance figures are not indicative of future performance. This communication is provided for general information only and assumes a certain level of knowledge of financial markets. It is not an invitation to make an investment nor should it be construed as advice. All the information in this communication is believed to be reliable but may be inaccurate or incomplete. The views in this communication are those of the contributor at the time of publication and do not necessarily reflect those of Investec Asset Management. Any opinions stated are honestly held but are not guaranteed and should not be relied upon. This is not a buy, sell or hold recommendation for any particular security. In South Africa, Investec Asset Management is an authorised financial services provider. In Hong Kong, this content has not been reviewed by the SFC and is issued by Investec Asset Management Hong Kong Limited. In Singapore, this content is issued by Investec Asset Management Singapore Pte Limited (Co. Reg. No. 201220398M). In Australia, this document is provided for general information only to wholesale clients (as defined in the Corporations Act 2001).

The content of this page is intended for investment professionals only and should not be relied upon by anyone else

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