Lessons from the latest market tantrum

By Steve Brice

The fourth quarter of 2018 was the second-worst quarter for global stocks since the 2008 financial crisis. No major equity market was spared. A benchmark of global stocks dropped 13% during the quarter, and 11% in all of last year, recording its biggest annual loss in a decade as investors were spooked by the US Federal Reserve’s interest rate hikes amid slowing global growth and corporate earnings. 

What can we learn from the latest market tantrum and how do we use the lessons to position for 2019?  

Let’s start with arguably the most reassuring aspect of the latest volatility. As stocks plunged, bonds and other so-called ‘safe-haven’ assets rose. An index of US Treasuries gained 2.6% during the fourth quarter, gold rose almost 7% and the Japanese yen strengthened 3.7%. This resurrects the traditional role of these assets as an offset against equities. 

The main lesson for investors here is that of the importance of diversification. Our preferred broad-based allocation for conservative investors, spread across Developed and Emerging Market stocks, government and corporate bonds, gold and other alternative assets, lost only 2.1% in the last quarter and 1.3% in all of 2018, significantly outperforming a portfolio focused solely on equities. 

One cannot overemphasise the benefits of diversification, especially as we get closer to the end of the current economic cycle. Too often, investors over-allocate towards their preferred asset class and markets, thus taking on inordinate amount of risk, only to suffer significant drawdown when markets turn against them. There is now a significant body of academic research which shows that an investor’s asset allocation contributes most of his/her investment returns. A broadly diversified allocation helps maximise returns for a given level of risk appetite.

Once an investment portfolio is broadly diversified, the next lesson is that of rebalancing the portfolio to bring various asset classes to their desired allocations. This is typically done once or twice a year. The recent market volatility would have made it particularly necessary for most investors. 

For instance, the drawdown in stocks in the fourth quarter of 2018 likely reduced their share in the overall investment allocation below the desired level. The pullback would be a good opportunity for investors to rebalance their portfolio by adding to their equity holdings at a more attractive price, while trimming other assets which may have exceeded their desired weights due to outperformance. 

Such a rebalancing strategy is a disciplined way of following the time-tested principle of ‘buying low and selling high’. 

The recent volatility also highlights the importance of holding a reasonable cash balance. In early December, when we issued our 2019 Outlook report, we concluded it was time to dial back our positioning in risk assets and raise allocation to cash. The rationale for this decision was threefold – first USD-denominated cash yields have increased from virtually zero during a large part of the current economic cycle to levels which are now attractive, both in absolute terms and relative to other asset classes, once adjusted for the volatility of various assets. 

Second, we believed markets will continue to be volatile in 2019 and holding a sizable allocation in cash would help reduce the volatility of the overall holdings. 

Finally, we want to have cash as reserve firepower which can be deployed quickly when short-term, tactical opportunities present themselves.

December’s market tantrum has presented a few such opportunities to add exposure. For one, valuations for US equities have turned more attractive on the back of strong corporate earnings growth and recent weakness in prices. For sure, there are increased concerns about the possibility of a US recession over the next one to two years. However, our scorecard, which incorporates a wide array of factors to assess the risk of a US recession, does not have many signals that are flashing red, at least for now. 

In fact, we expect healthy but modestly slower pace of US growth this year fuelled by solid consumption and the lowest unemployment rate in almost 50 years. If the current economic cycle, now in its 10th year, stretches until Q2 of 2019, it would be the longest US expansion in modern history. 

We also believe US inflationary pressures have peaked. The combination of slowing, but still-robust, economic growth and near-target inflation implies the Fed is likely to hike rates at a much slower pace than in 2018, possibly even pausing in the first half of the year to assess the impact from its previous rate hikes. 

A cautious Fed is likely to be positive for US equities over the coming months. Asia ex-Japan and other Emerging Market stocks could also benefit from a Fed pause. A breakthrough in the current trade talks between the US and China to help resolve their disputes would also be positive for these markets. 

In early December 2018, we turned more constructive on bonds generally, although the decline in US Treasury yields since then makes us more selective. In the higher yielding area, Emerging Markets USD-denominated government bonds are particularly attractive. They now offer similar yields compared with Developed Market High Yield bonds, while bearing lower credit risk. Asian USD bonds have become more attractive over the past year. While China-related risks are a justifiable concern, the market is already pricing in elevated default rates at a time when China’s authorities are increasingly taking measures to support growth.

All in all, the recent market tantrums would have undoubtedly dented the risk appetite of many a hardy, battle-tested investor. Yet, that is just the time to rebuild positions, especially in areas which have turned more attractive. We believe 2019 is likely to offer many such tactical opportunities.    

The writer is the Chief Investment Strategist at Standard Chartered Private Bank.