The calendar has changed to 2016, but the volatility story remains. The key concern: weaker global growth and its possible ripple effects, including low oil prices for an extended period. How should investors approach this challenge?
First, the backstory. Risk assets, led by energy stocks, took the brunt of the recent market sell-off; safe-haven assets, such as US and German government debt, gold and the yen, rose. Investors fear that the market slump also signals weakening global demand: China’s 2015 growth was the slowest in 25 years, and global gross domestic product forecasts for 2016 were reduced.
There’s also concern about the potential damaging effects of deflationary forces on corporate profits and balance sheets, including those of banks with exposure to commodity markets. Here’s our assessment, and some things for investors to consider.
Little Change in Macro Outlook
Fundamentally, we don’t see a significant deterioration or change in our macro outlook. China’s growth will likely slow as it continues the difficult transition from an investment-led economy to a more consumer-oriented model. This will take time and create more volatility.
But lower oil prices appear driven more by higher supply than by lower demand. The odds of a global slowdown have increased, but we don’t expect a recession in the US or other developed economies. Energy and materials companies have struggled with lower commodity prices, and further price weakness doesn’t help, but earnings expectations and sentiment for these companies are already quite low.
As the earnings reporting season starts, it’s critical to monitor developments both at the company level and macro level. Investors should be ready to adjust portfolio positioning as opportunities and near-term trouble spots emerge.
Managing Portfolio Exposures in Volatile Times
At the broader portfolio level, investors need to balance long-term objectives with managing recent bouts of volatility. We expect “risk-on/risk-off” conditions to persist, but from a fundamental point of view, we haven’t seen any material deterioration in developed economies. This suggests that spillover effects are likely to be limited.
In a risk-on/risk-off environment, volatility itself is volatile, and a single concern or factor drives market moves. There are bouts of volatility and sharp price swings—both up and down. The key dilemma for dynamic allocation strategies is to determine whether each new episode is simply another short-lived bout of anxiety or the start of a sustained directional move.
So investors should think carefully when considering adjusting long-term portfolio exposures in an effort to reduce risk—a starting point might be staying close to strategic allocations. And they should avoid using a narrow set of volatility-based triggers to help set allocations; portfolios could be whipsawed by each new market move. We think the right approach to gauging volatility is broader—open to multiple signals and to the integration of both fundamental and quantitative assessments.
Look for High-Conviction Stock Opportunities
After a long bull market, it’s not unreasonable to see more divergence among companies’ ability to deliver earnings and revenue growth. At times like these, when earnings growth is becoming scarcer, it’s critical to identify companies that are well positioned for the future.
In general, we don’t think overexposure to energy companies is warranted. Instead, investors should focus on select high-quality, low-cost producers. We’re also finding opportunities in companies that benefit from lower energy prices, such as airlines, automakers and auto-parts suppliers.
Market corrections are a normal part of equity investing, and they can actually be healthy from a longer-term perspective. For one thing, valuations have become more attractive today, even assuming modest declines in forward earnings estimates for the broad market.
It’s very difficult to accurately time market cycles, so today more than ever, it’s important to remain invested in active equity strategies that provide selective, high-conviction exposure to stocks with company-specific return drivers and the ability to navigate turbulent times.
Balance Interest Rate and Credit Risk in Bonds
The yield-spread widening we’ve seen since mid-2015 means bond investors are now being better compensated for taking on the risks of nongovernment bonds. But it’s important to be choosy, especially in sectors that are still in late stages of the credit cycle.
We still see attractive opportunities where valuations are at odds with fundamentals, such as in sectors tied to the rebound in US consumer spending (think consumer asset-backed securities) and the rebound in the US real estate market (commercial and residential mortgage-backed securities).
High-yield energy sector exposure should be modest, in our view, but there’s value in other areas of the market. In many ways, high yield today looks like it did in 2002; the bursting of the dot-com bubble battered the debt of overstretched telecoms, but left other sectors attractive.
In broader bond portfolios, investors should balance credit risk and interest-rate risk, focusing credit exposure in countries where growth is strong—primarily the US. Rate exposure should be focused in economies where growth is weaker and central banks are either cutting interest rates, engaging in quantitative easing, or both.
Economic activity in most emerging markets continues to disappoint. But economies with strong links to US growth and the European recovery are likely to benefit in the months ahead, even as those more closely linked to the troubled Chinese economy face ongoing challenges. We see select opportunities in debt from emerging-market corporate issuers with dollar-based revenues that can benefit by exporting into a more stable global economy. Local-currency debt exposure should be limited.
The Liquidity Angle
Investors should also continue to keep a close eye on global bond market liquidity. Diversifying, using cash and other instruments as liquidity buffers, and managing turnover in investment strategies to limit transaction costs are all steps that can help manage liquidity risk. These approaches may also enhance returns as opportunities emerge to become a liquidity provider.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.