2018 has seen the return of volatility. The biggest peak-totrough fall in global stocks last year was less than 3%. Already this year there has been a 9% decline. Choppier markets reflect concerns that the economic upswing will soon come to an end amid higher inflation, rising US interest rates, and the end of quantitative easing. Meanwhile, a trade dispute between the US and China threatens global growth.
Yet the return of volatility does not mean that it is time to sell. On the contrary, global growth is still good, earnings growth is strong, and equity market valuations remain appealing relative to cash and fixed income. In short, we think being invested in equities is quite likely to work in the short run, and very likely to in the long run. Timing an exit from stocks before the onset of a recession can be tricky. While the average rise in the final year of the bull market is 22%, the average recession is accompanied by an equity drawdown of around 20%, based on data since 1928.
Investors need to both be invested and manage risks. Those in properly diversified portfolios are well prepared for the return of volatility. But many others are not relying too heavily on passive approaches in traditional markets; not managing equity downside risks appropriately; holding concentrated positions; focusing too heavily on generating yield while neglecting risks; and lacking a suitably long-term approach.
To prepare for this new environment, we recommend five main approaches:
- Adding alternative sources of return beyond classic equity and bond indexes, such as hedge funds – which often outperform later in the economic cycle – and smart beta strategies.
- Lowering vulnerability to equity drawdowns. For those investors who can use options, one method of downside protection is to buy put options. When options aren't appropriate, diversification, systematic rebalancing, and setting aside funds for short-term spending can provide equally effective protection. For more, see Options for navigating choppier waters.
- Diversifying globally can help reduce exposure to specific risks. Those averse to owning foreign equities can also seek out homegrown companies with high international exposure.
- Reconsidering sources of income away from risky credit. The yield on riskier corporate bonds is no longer sufficient to compensate for a rise in defaults. Investors looking to earn yield without taking on excessive risks can consider the House View Yield-Focused SAAs, dividend investing, and longer-duration government bonds (which can also offset market turbulence).
- Looking beyond the economic cycle with allocations to private markets, sustainable investments, or long-term themes (like Fintech or robotics), can help boost returns or reduce the temptation to sell at the wrong time and retreat to cash.
Investors should prepare their portfolios for the return of volatility. But with economic and earnings growth still strong, we do not believe that cash is the right response. Instead, by seeking alternative sources of return, adding downside protection, and investing with a longer-term mindset. investors can reduce drawdown potential, and position for long-term portfolio growth.