Although markets began 2018 against a rather benign backdrop, history suggests it's unlikely that the remainder of the year will be a repeat of the relative calm of 2017. As a result, investors should be mindful of the current environment and its potential risks, and begin preparing for a more uncertain future.
This isn't to say that broad asset allocation shifts are necessary, but rather a review of a current portfolio's positions and preparations for a timely transition when conditions warrant. This preparation should be considered spring cleaning rather than portfolio remodeling, focusing on three main categories:
Despite recent volatility catalyzed by trade conflicts and policy turmoil, global growth likely will remain strong throughout 2018 given the level of ongoing monetary accommodation and stable inflation. Current conditions have allowed central banks to remain patient, pursuing only a very gradual process of policy normalization. While this policy normalization eventually will create a more challenging environment for risk assets, significant deterioration in fundamentals is not anticipated until sometime in 2019. At that point, central banks will have shifted from a stance of slowing accommodation to an actual reversal and any modest, positive fiscal stimulus from U.S. tax cuts likely will have run its course.
To characterize market risk, Pavilion uses a risk management framework to evaluate risk on three dimensions: cyclical factors, valuation and financial stresses. Cyclical risks and financial stresses appear low — key reasons we believe risk assets can continue to provide positive, if more muted performance over the next year. However, as we enter an environment in which the economic recovery pace slows as interest rate increases begin to weigh on growth, now is a good time for investors to take stock of their positioning and prepare for the risks that might lie ahead.
As portfolio managers begin this spring cleaning process, they should check that adequate liquidity exists in each portfolio sleeve such that rebalancing to capture diversification benefits and tactical positioning can be undertaken in a timely, cost-effective fashion.
At the same time, managers also should look for opportunities for diversification and to build in a portfolio stabilizer through fixed income. We anticipate any interest rate increases to be gradual, with rates normalizing well below recent historical averages. As a result, duration can provide investors with protection against a future policy misstep or other unforeseen circumstances. We favor high-quality bonds that are unlikely to be adversely affected by a risk-off or negative credit event. If alternative strategies have been selected for diversification purposes rather than alpha sources, test their diversification potential in risk-off environments. Consider leverage, net exposures, beta exposure, down market capture, liquidity, position sizing and the manager's risk management practices.
Volatility is the third key consideration as part of this spring cleaning. Portfolio managers should look to reduce credit spread duration exposure, as credit spreads are highly correlated with volatility and have tightened significantly in the recent low volatility environment. As the cycle extends and approaches an inevitable turn, volatility will increase causing spreads to widen. With credit spreads at tight levels, very little upside beyond pure carry exists, providing investors with limited protection from future bumps in volatility, and a performance pattern that will be highly correlated with equities.
Now is also a good time to evaluate equity portfolio structure. Passive management and some concentrated active equity managers have performed well during the current bull run due in part to the dominant performance of momentum. Unfortunately, momentum works in a similar fashion when markets turn. Portfolio managers should assess whether the index fund in use remains appropriate or whether a shift to a broader benchmark would lower risk. Many active managers have demonstrated an ability to outperform in down markets, as they avoid momentum (explicitly or implicitly). As a result, these active managers can add positive downside convexity, providing outperformance, in down markets. A shift in the allocation among managers might result in a lower volatility level as well.
Additionally, we would recommend considering overweighting U.S. and emerging market equities and underweighting developed international equities. This positioning maintains exposure to global growth while reducing exposure to volatility that might result from slower growth or policy disruptions in some developed markets. Finally, consider alternatives strategies that might provide downside protection in the event of a market correction.
Now is a good time to embark on a portfolio "spring cleaning" that focuses on liquidity, diversification and volatility.
Robert Lee is research director, risk management and strategic analysis, and Susan McDermott is chief investment officer at Pavilion Advisory Group Inc., based in Minneapolis and Chicago, respectively. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.