Defensive play: hedging against rising uncertainty

Equity markets could be in for a downturn, calling for a balanced investment approach

The US equity market bull-run is in its eighth year, and – if the S&P500 index holds up until the end of May – will be the second-longest in US history. This begs the inevitable question: is this going to last? And, if not, how could investors hedge against an eventual downturn?

The first question is always difficult to answer with any degree of certainty. This became apparent in the first quarter when US stocks plunged more than 10 per cent from the start of the year until mid-February, only to bounce back and recoup the early-year losses by April. The factors behind the early-year sell-off – concerns about slowing growth in the US and China, falling commodity prices and worries about a sharp devaluation in the Chinese currency – also led to the subsequent rebound as those concerns eased.

However, investors should not be lulled into complacency by the recovery in riskier assets – which included a strong rebound in commodities, emerging market stocks and higher yielding bonds from oversold levels.

In our view, the latest rally masks an increasingly uncertain outlook for global growth and earnings. Economic headwinds from the US and Japan also warrant a cautious investment approach. Given this, we believe the rally offers an opportunity to partially rebalance out of equities into more defensive assets, such as bonds and alternative strategies, which are less likely to move in tandem with equity markets.


Headwinds from the US

US corporate earnings are forecast to have fallen by 6 per cent in the first quarter of 2016 from a year ago. That would make it the third straight quarter of earnings decline. Although the energy and materials sectors are largely to blame, there are signs of broad-based weakness in demand – corporate revenues are estimated to have fallen for the fifth straight quarter. For sure, we are seeing some stabilisation in full-year earnings expectations after several months of downgrades, but this needs to be watched closely.

Moreover US wages, which have remained subdued so far, may become a concern over the coming months as the job market tightens. Also, there has been a perceptible downtrend in US auto sales since late last year, taking the shine off a recent pick-up in manufacturing sector business confidence.


Headwinds from Japan

Meanwhile, Japan’s economy has taken a turn for the worse.

The Bank of Japan's latest ‘Tankan survey’ of Japanese businesses showed manufacturers were downbeat on the outlook for business conditions and investment spending as the Japanese yen rebounded, making exporters less competitive; annual spring-time wage negotiations for the manufacturing sector were disappointing, and there are increasing questions about the Bank of Japan’s ability to revive growth and inflation – all of which have raised doubts about the Prime Minister’s plans to revive the economy through fiscal and monetary stimulus and structural reforms.


Time to be cautious

Although equities could still deliver positive returns, the uncertainty surrounding these returns has risen significantly, in our opinion. As a result, after years of adding exposure to equities, we believe it’s time to adopt a more balanced approach. For a multi-asset investor, the recent rally offers an opportunity to shift the risk profile to a more conservative stance, moving towards bonds and alternative assets.

Within fixed income, we prefer corporate credit, especially US investment-grade bonds.

In Asia, we favour regional US dollar-denominated investment-grade corporate bonds, as the region’s emerging markets remain healthier than developing economies in other parts of the world, such as Latin America and Eastern Europe, partly due to its lower exposure to commodities, sturdier external balances and stronger domestic demand. Investment-grade corporate bonds could also mitigate the risk that China’s slowdown could lead to deterioration in credit quality, in our view.


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