Drop is signal to firms that opportunities still can be found in market
While money managers are split as to whether February's market dip was the time to add risk to portfolios, they agree subsequent dips — and the anticipated return of volatility — will be altogether more attractive.
From Jan. 31 through Feb. 9, the S&P 500 fell 7.2%, following a strong January with gains of 5.6%. The MSCI Europe index lost 6.9% compared to January's 1.6% return, and the MSCI Emerging Markets index lost 7.6% over that early February period, vs. 7.8% growth in January.
Sources largely attributed the dip to technical, rather than fundamental, factors and a volatility shock. They cited concerns over rising inflation in the U.S. in particular, jitters over central bank policy changes and volatility-focused strategies.
"The recent sell-off appears to have been a volatility shock," said Tristan Hanson, multiasset fund manager at M&G Investments in London. "Asset price movements can cause investors to start looking for reasons to explain market reactions, such as last month's upside surprise in wage inflation, but it is impossible to know with certainty why markets move when they do."
Whatever the reason for the sell-off, some managers agreed that what mattered more was the opportunity afforded by it to long-term investors, providing an entry point for investment.
And they agreed that the sell-off was probably the start of an altogether more exciting time for active stock pickers.
BNP Paribas Asset Management executives have embarked on a "road map so far this year … to gradually add to risk on dips," said Guillermo Felices, head of research and strategy in the firm's multiasset, quantitative and solutions unit in London. Executives are operating on a central scenario of continued robust growth and contained inflation, an environment that is "typically good for risky assets. Along that macro path you can have setbacks, shocks that are sometimes unrelated to those macro assumptions, and those are the ones that give you opportunities," Mr. Felices said.
Mr. Felices did warn, however, that 2018 will be a difficult year. "The difficulty is summarized by the tension between two forces: a global economy that is still doing well — with robust growth and inflation that is well-behaved; and on the other hand a rally in equity markets that has lasted for a long time."
He added: "We need to be very careful about two things: hedging our exposure to risk if (there is a) material risk we need to consider, and being a bit more nimble or active in managing our risk exposure."
Sign of things to come
Russell Investments' David Vickers, senior portfolio manager in London, agreed. "In terms of is this a sign of things to come, I think the answer is yes. We are now in a world — finally, in our view — of higher rates and quantitative tightening, as opposed to easing, and also potentially higher inflation. The market has to digest that. Also, volatility has returned to more normalized levels. It doesn't mean that risk markets can't appreciate in value, but just that risk will be more visible than it has been over the last year, and not all investors may appreciate that," Mr. Vickers said.
But there is reason to be cautious. Executives at Hermes Investment Management are debating how expected interest rate rises will influence companies and the markets.
"Current expectations are for three or four rate rises in the U.S. in 2018, but if rates rise too fast it could have a major impact on companies that have binged on the historically low rates, especially those that have not borrowed to invest in the future," said Louise Dudley, London-based portfolio manager, global equities. "This view has led to more attractive valuations within banking names and the taking of some profits in the growth areas of the market."
Another concern relates to valuations, which were "widely touted for most of the latter half of last year. In a higher rate environment, the increased discount rate could lead to lower valuation multiples," Ms. Dudley said.
And while Ms. Dudley said there is little sign of the economic recovery running out of steam, increasingly protectionist rhetoric — particularly from the U.S. — provides another reason for caution. "If it becomes reality, it would likely have a severe impact on global trade and the economic recovery. Given these concerns, we should expect increasing dispersion between the winners and losers, which allows active stock pickers greater opportunity to add value. We are cautiously optimistic on the longer-term trajectory of markets," and Hermes executives are focusing on companies showing strong robust growth, "particularly disrupters that are gaining market share and delivering market beating returns," she said.
Executives at Goldman Sachs Asset Management also are cautiously optimistic. "Given the growth outlook and continued earnings growth improvement, we do not believe the recent drawdown is foreshadowing an imminent end to the bull market," said Shoqat Bunglawala, head of the global portfolio solutions group for Europe, the Middle East and Africa, and the Asia-Pacific region, based in London. "Instead, we think it's generally safe to buy on dips."
But executives also acknowledge that "rising interest rates are putting some pressure on equity valuations, and this puts the market at risk to additional corrections," Mr. Bunglawala said.
And Legal & General Investment Management's multiasset investors "expect there to be at least one more episode this year, and whether or not we buy it will be dependent on the fundamentals between now and then," said John Roe, head of multiasset funds in London. "If growth remains strong and inflation remains subdued, then we'd be more likely to buy future dips. However, if inflation picks up faster than expected, or we see more pronounced contagion effects from quantitative tightening, that would make us more cautious." The firm bought equities in the February dip.
Change in mindset
The move into a more volatile market environment does require a shift in thinking. "The issue is that in the last few years we've had this Goldilocks situation of policy being pretty benign, growth has been there but not excessive, and inflation has been under control," said David Docherty, a U.K. equity fund manager at Schroders PLC in London. "That narrative has helped markets do well."
While "everything was rosy in the garden," hints of inflation becoming an issue in February called that environment into question. "I suspect people will continue to be looking very carefully at this narrative," Mr. Docherty said.
Despite Psigma Investment Management's view that February's move "was not a crisis" but a correction, the feeling is that the next dip might be a buying opportunity. "We would like to see more of a pullback before buying back into equity markets," said Rory McPherson , head of investment strategy in London.
Instead of buying into the most recent dip, Psigma executives are waiting for the next one. "The underlying environment is good, but we still think investors are too complacent, hence we believe there is a bigger correction on the cards — still in the context of rising equity markets but where risk markets return to normal, and not that surreal" of an environment as recent times where all markets moved upward.
Psigma executives are holding a maximum 5% cash and also have parts of the portfolio that are fairly defensive, including absolute-return funds and short-duration bonds. Those are "steady eddies that chug along ... (that) we could move from. But these shakeouts throw up different opportunities outside of stocks," Mr. McPherson said. On the firm's "hit list" are infrastructure stocks and gold. "We'd look to get into (those assets) if we get a buying opportunity in markets."