Three inconvenient investment truths

The volatile start for investors in 2016 highlights the virtues of diversification

Global markets have had a rather rocky start to the year, to put it mildly.

The MSCI AC World Index fell as much as 19 per cent from record highs in May 2015. Meanwhile, the MSCI Emerging Markets Index lost as much as 35 per cent from last year’s peaks. Given the turmoil of uncertainty, we believe it is time to face some inconvenient investment truths.

1. Economic turning points matter

Global equity markets on average peak approximately six to seven months prior to the start of a US recession and bonds normally bottom around six months prior. Getting the timing of when the US falls into a recession is therefore critical to investing.

2. Economists tend to have a poor record of predicting recessions

While equity markets famously predict more recessions than actual occurrences (think about the number of times equities fall more than 20 per cent into a technical bear market but are not followed by an economic recession), economists predict fewer and are usually way too late, as demonstrated by the 2001 recession when economists predicted a US recession after the 9/11terrorist attacks in New York.

Yet, according to the National Bureau of Economic Research, the entity responsible for dating US recessions, the recession had already started six months earlier – in March 2001. In fact, the recession was over by November, two months after economists started worrying about it. It would be nice if this was an abnormality, but the 2007 experience when the Federal Reserve itself failed to anticipate the downturn reinforces the challenges economists face when it comes to predicting recessions.

3. Nobody knows for sure what is going to happen

In the US, at current unemployment levels the probability of a recession over the next 12 months is around 10 to 20 per cent. The US services sector is thriving on the back of record low borrowing costs, low energy prices and strong consumption. Yet, the manufacturing sector is contracting as the strong US dollar is hurting exports and making imported goods more competitive, while falling oil prices are leading to more bankruptcies in the energy sector.

The tussle between sectors performing in opposite directions in the US is likely to continue causing volatility in the markets, as will China’s ongoing shift towards a consumption-driven economy and its efforts to make its currency more responsive to market dynamics.

Meanwhile, there is a risk that rising tensions in the Middle East could result in a sharp rise in oil prices and a cut in discretionary consumer spending. For now, oil prices are moving in the opposite direction, of course. However, one lesson from the past 18 months is that things can change quickly, especially in commodity markets.

Given the uncertainty, we believe in adopting a probabilistic, as opposed to a deterministic, approach to investing, making diversification increasingly important.


Time to adapt portfolios

So what does this mean?

Investors have a natural tendency to only buy assets that have been rising in value for a period of time. The problem is nobody knows with any degree of certainty whether they will continue to appreciate. We expect the US economy to continue its expansion for an additional 18 to 24 months, Europe and Japan to accelerate modestly and China to manage a soft-landing of its economy. As such, we remain comfortable with significant exposure to global equities.

But there are always risks that the economy does not pan out as predicted. And, even if our expectations are right, as the US economic cycle matures, equity returns are likely to see significant bouts of volatility.

Adopting diversification across various uncorrelated asset classes, such as equities, high-grade bonds and alternative strategies, is therefore vital. It’s a time-tested principle that provides protection from downturns in any one particular asset class.

However, long-drawn equity bull markets – such as the one we have had for the last six years – tend to lull one into complacency.

The recent bout of market volatility is a good reminder of the virtues of diversification.


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