By Mark Hamilton, Chief Investment Officer, Asset Allocation
A few months ago, I was traveling in a snowstorm to meet with a group of advisors. Stocks were down over 10% year to date, oil had dropped to under $30 a barrel, and high yield spreads had blown out to more than 800 basis points, the widest levels since the debt ceiling debacle in 2011. Fear was in the air, as was apparent in the questions the advisors and their clients were asking: "Is this another 2008?" and "Are we heading for a recession?" were top of mind.
While our Global Multi-Asset Group entered this year expecting more bouts of market volatility and lackluster investment returns, my response to these questions stressed that the market drawdown had run well ahead of the "slowdown" environment indicated by our macro regime indicators. We didn't see anything in the current data that indicated a recession was on the horizon, and we certainly did not believe that conditions were ripe for a financial meltdown, but we also recognized that multiple bouts of market volatility can deter the "animal spirits" of consumers and corporations that are necessary ingredients for economic growth.
So, here we are a few months later. Spring has come to New York, and markets have recovered nicely over the last month. Stocks are within shouting distance of flat for the year, credit spreads have rallied, and oil has bounced to over $37 a barrel. The European Central Bank (ECB) announced significant additional policy stimulus yesterday, and even the Federal Reserve's (Fed) rhetoric has softened in recent weeks, led by Governor Brainard but notably seconded by NY Fed President Dudley. All of which could continue to give risk assets a lift over the near term.
But has anything fundamentally changed?
Or, more to the point, do we see reasons to change our view that 2016 is likely to be a mediocre year for asset returns against a backdrop of further bouts of market volatility?
In short, I would say no.
Our overall thesis is that markets have entered a new stage in the recovery from the Great Recession. From 2012 through 2014 a virtuous combination of economic recovery, low volatility, cheap assets, and widespread monetary stimulus drove markets higher, particularly developed market equities and credit. By the middle of 2015 we saw signs that the environment was changing. Growth was slowing, volatility was increasing, valuations were fair to full, and additional rounds of policy stimulus were delivering diminishing benefits.1
Today, the key perspectives that drive our investment process still support this thesis:
- From our macro perspective, most developed economies (U.S., Europe, U.K. and Japan) are in the "slowdown" regime, which is typically a highly uncertain environment with mediocre compensation for risk taking. Among emerging markets, the decline in China shows signs of stabilizing over the near term, but it remains to be seen whether this will be a durable improvement;
- From a risk perspective, short-term indicators such as the CBOE Volatility Index have declined, but our intermediate-term measure remains high;
- And valuations indicate that compensation for risk is not that compelling, particularly in the U.S. Only in credit are valuations notably attractive versus long-term measures.
- Underweight equities about 7%, spread across global equity markets proportionally;
- Neutral duration to benchmark, with exposure primarily in U.S. Treasuries;
- Broadly underweight credit, though we are looking at opportunities to swap some equity exposure into credit on a relative value basis;
- A modest increase in U.S. dollar exposure to about 5% long from neutral, versus hedged positions across several developed market currencies; we've been neutral on the U.S.$ since early December, but believe that conditions are coming together that could drive a resumption in dollar strength.
On this last point, one of our major concerns as we look forward is that the recent improvement in financial conditions and continued strength in the U.S. labor market will embolden the Fed to tighten monetary policy, likely by more than the market is currently discounting. We believe that this would lead to renewed risk-off pressures, particularly through a rise in the dollar.
Since last August, investors have endured two significant spikes in market volatility with equity drawdowns in excess of 10%. While markets recovered reasonably quickly in both cases, the S&P 500 Index remains about 7% below its highs of 2015. We expect we may see more bouts of volatility over the course of the year, and are pursuing a cautious strategy accordingly.
- See, for example, the 3/11/16 reaction to the ECB's announcement. While markets initially reacted positively, European markets nearly reversed themselves by the close: stocks were down, yields were up, and the euro was higher. It was just one day's response, and it is too soon to read much into it, but it was disappointing nonetheless.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.