Tapan Datta, global head of asset allocation
For some time now, we have regarded market conditions to signal a ‘transi- tion’ environment. Our timing indicators suggested that we moved into a tran- sition phase sometime in the first half of 2018, taking us from a long period of risky asset strength towards an eventual market downturn phase when bonds will be the only performing asset.
A question we are often asked given the length of the current bull market1 is when will the ultimate market downturn arrive. A large market downturn still does not appear imminent but sometime within the next year or at most two, looks a reasonable expectation for such an event – by the summer/autumn of 2020 we estimate we’ll have been in a transition environment for some two-and-a-half years.In this environment, markets will go through several mini-cycles. Volatility will go higher in a jumpy, discrete process that essentially reflects the higher level of economic and market uncertainty.
It is not necessarily the case that these asset moves are synchronised in the transition phase; only in the final market large draw-down phase are there sympathetic moves in risky assets across the board. Market leadership at sector and stock level can change drastically, though this is not a given. Three main factors will determine the likelihood and scale of such shifts: Valuation anomalies, economic conditions and policy reactions.
Market phasing
Market cycle measurement typically focuses only on rising and falling risky asset performance centred on equities. This does not recognise the intermediate or transition phase we are referring to here when risky assets start to perform less well.
Typically, transition markets see a tussle between factors pushing markets higher, and those which are pulling markets lower. Down markets should be seen as the end of a process which is set in motion in transition environments. It is what happens in the transition phase that ushers in the final market phase of sharp falls in risky asset prices and outperformance of defensive assets.
Triggers for the beginning of the transition
We are in an environment where the longevity of the global business expansion that began 2009 is now looking suspect. US policy interest rates have risen, broad financial conditions are tightening, and expansionary fiscal policy is likely to create added strain at a time when US labour markets are tight and expansion capacity is limited.
At the same time, global threats to the economic expansion are rising, given more trade protectionism and growing economic divergence between the US and other regions. The economic risks from this are seen in a flattening US yield curve.
Notwithstanding their setback through the end of 2018, equity markets and risky assets in general remain on rougher ground given the change in monetary conditions and narrow risk premiums. Low long duration bond yields still provide some support to equities, but high valuations look less sustainable given the broader economic message from low bond yields and poor economic data.
Triggers for the end of the transition
The transition phase ends as a logical culmination of the changes that are occurring through time. How- ever, a ‘shock’ of some kind is probably needed. This shock could come from some economic develop- ment – a significant rise in inflation which brings concerns of faster-than-expected monetary tightening, or a major economic growth slowdown that comes from either the lagged effect of higher interest rates or the creeping effects of trade protectionism.
Alternatively, a shock can come from seemingly nowhere, such as a more pronounced challenge to the Eurozone from Italy or a large devaluation in the Chinese currency.
Portfolio challenges in a transition environment
Staying the course with risk asset markets appears a gamble given the likelihood of the ultimate large reversal. However, anticipating the downturn by selling risky assets is also a problem since the transition phase can still see the market gain significantly over its duration.
Neither is diversification into assets with intermediate risk-return characteristics that easy a compromise. The diversification promise may not materialise one way or other as made clear by the experience of the financial crisis and the very low return profiles in some cases thereafter (as with most hedge fund strategies).
What should be done?
It appears to us that the better course is portfolio adjustments that incrementally move towards lower risk-taking. Ultimately, making some moves, even if early, will be better than taking no action at all. Here are some actions to consider, most of which are standard risk mitigation measures:
- Looking at more defensive approaches within asset classes as well as across the broader mix of assets.
- Using diversifiers where not currently much used or raising exposures in this area – intermediate riskreturn assets are the opportunity set here.
- Using any weakness in bonds to build or increase positions. Clearly the higher yields are, the more it pays to build positions, but it is time in these conditions to not be too greedy on yield levels.
- Considering portfolio overlay-type protection strategies. With the timing of market downturns uncertain, open-ended protection strategies would seem best, if available and affordable.
Ultimately, it must be appreciated that in dealing with a transition environment, some risk will have to be taken. Either it will be a case of being too early and foregoing gains directly or costs incurred from purchasing insurance; or in the case of not doing anything or not doing enough, of being too late to protect capital adequately.
It is weighing up these opposing risks for portfolio moves that make the transition environment so challenging. It should hopefully also be clear that this challenge cannot be avoided. Market cycles are like that.
