Clarity from chaos?

As the financial world looks back at the Lehman Brothers bankruptcy, it is hard to remember that, in the moment, the event wasn't seen as a turning point. Few people recall that the global equity market traded up in the week after Lehman Brothers’ collapse. Most like to believe in one decisive thing that gives clarity to chaos, but markets will never make it that easy. At the time, the market saw Lehman Brothers as one more piece of news that might influence the complex interaction of fiscal, monetary, and corporate policies. Even today, people still argue over how different responses to the Lehman Brothers event could have made the unfolding scenarios better or worse. With the humility that comes from the study of history, we attempt to pursue an investment course through the inevitable uncertainty of current events.

Mark Haefele

Chief Investment Officer
Global Wealth Management

Key risks to watch

While I’m not predicting any event risk as consequential as the collapse of Lehman Brothers in the near future, we will need to pay close attention to a number of key risks that could impact global market performance in the months ahead. Of course, there are also many more localized risks that might not have global implications, but could be very meaningful for investors heavily concentrated in specific markets.

Accelerated Fed rate hikes

Our view

We expect the Federal Reserve to raise rates four times by the end of 2019. Our forecast for a steady rate hike path is already largely priced into the market.

But what can go wrong?

If US companies need to increase pay significantly to attract workers or increase prices to ration demand, the risk of more aggressive rate hikes will increase. Rapid rate hikes would likely have a negative impact on risky credits, emerging markets, and equities.

China economic slowdown

Our view

We expect only a modest slowdown in growth from 6.5% in 2018 to 6.0% in 2019. The recent shift to easier monetary, fiscal, and credit policy has helped stabilize activity data.

But what can go wrong?

China's growth is challenged by sluggish growth in fixed asset investment and the vulnerability of exports to trade tariffs. A slowdown in Chinese growth could have severe negative consequences on equities (particularly in Asia), commodities, and Asian credit.

Escalating trade tensions

Our view

We expect US-China trade tensions to get worse before they get better. However, we do not believe tariffs will be significant enough to cause a global market shock.

But what can go wrong?

If additional countries become involved or are affected by the dispute, GDP could slow 0.5-1.0% relative to our base case. Trade-dependent markets like Germany, Japan, and emerging markets could be expected to suffer most, alongside cyclical sectors like industrials and commodities.

Oil supply shock

Our view

We expect a tight oil market to lead Brent crude oil prices to USD 85/bbl over the next six months.

But what can go wrong?

A sharper-than-expected drop in Iranian exports, or Iranian retaliatory measures against US sanctions could result in a spike in oil prices. We estimate that oil prices of USD 120/bbl would be sufficient to contribute to a sharp slowdown in global growth, hurting risk assets.

Are you prepared?

Some investors might have cause to focus on individual risk scenarios and prepare for those specifically. But most need to consider risks in aggregate while balancing them against the continued economic strength driving world markets. To reduce portfolio vulnerability while remaining positioned for growth, investors should consider five key questions (click each question for more information):

Background: Faster-than-expected Fed rate hikes could lead bonds and equities to fall in tandem.

Recommendation: Less correlated investments, such as smart beta or hedge funds can help diversify your portfolio against exposure to this risk.

Background: Low yields have tempted many investors to seek higher returns by taking additional credit or foreign exchange risks.

Recommendation: As the cycle matures, investors need to evaluate whether such risks are now worthwhile and should look to diversify fixed income holdings, improve credit quality, and extend duration.

Background: For investors, familiarity tends to breed comfort rather than contempt. Yet investing too many of your assets close to home usually adds unnecessary risk.

Recommendation: Make sure your portfolio is diversified globally across geographies and monetary regimes.

Background: Investors sitting on equity profits but now feeling uneasy about pending risks should avoid fleeing to cash for comfort.

Recommendation: We recommend remaining fully invested and diversified. Core bonds remain a diversified portfolio's main protection against bear markets, but investors may also want to consider direct hedges—such as put options—to protect against drawdowns.

Background: Panic selling is an important source of the long-term underperformance of private investors relative to market benchmarks.

Recommendation: Invest in assets with exposure to long-term drivers like population growth, urbanization, aging, or those exposed to secular trends.

Investment conclusion

Two months ago we reduced our exposure to risky assets since we did not think the market was sufficiently pricing in the second-order impact of tariffs. But while we continue to believe the trade situation between the US and China is likely to get worse before it gets better, the market has now had time to digest some of the impact. Therefore this month, we have added to our risk exposure by increasing our overweight to emerging market dollar-denominated sovereign bonds. We also maintain our modest overweight position to global equities.

These positions are complemented with some counter-cyclical positions that are designed to stabilize our portfolio in the event of renewed volatility. These include an overweight in 10-year US Treasuries and for those investors who can invest in options, a put option on the S&P 500.

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