by Kevin McCreadie, MBA, CFAĀ®, AGF Management Ltd.
Actively managing a portfolio of stocks, bonds and āalternativesā should help investors navigate the marketās latest bout of heightened volatility and position for better returns ahead, says AGFās CEO and Chief Investment Officer.
The U.S. equity market just endured its worst-performing January since the Global Financial Crisis in 2008. What are some of the ways that investors can navigate through the turmoil? Ā
It should go without saying but corrections have always created new opportunities for investors in the past. Regardless of how big, every selloff culminates in a rebound that eventually pushes equity markets significantly higher than they were before the selloff. Think about it, as it stands today, the S&P 500 Index has officially corrected more than 10% twice in a little under two years and the first of those corrections ā at the initial onset of the pandemic in the winter of 2020 ā was a 30% drop in value, according to Bloomberg data. Yet, despite that, the index is up more than 30% from its high just before that bear market happened, which is better, on an annual basis, than the S&P 500ās long-term average of around 10%.
Itās only a matter of time then before the market rebounds from this most recent correction, but that doesnāt mean investors should just wait it out and do nothing. The more active they can be to mitigate losses during a period of heightened volatility, chances are the better off theyāll be. Same goes for investors who anticipate what types of opportunities lie in store once markets do bottom and begin rallying higher again.
By extension, asset allocation is hugely important right now. In an environment of rising interest rates, itās probably not enough to rely on a 60/40 portfolio of publicly listed stocks and bonds without having a supplement of alternative strategies and asset classes that may provide a more reliable stream of uncorrelated returns.
In fact, while bond prices often rise when equity prices fall ā and provide the necessary ballast that traditional 60/40 practitioners seek ā that hasnāt been the case this time around, according to Bloomberg data. Based on a 5.6% decline in equities and a 2.2% loss in bonds, its namesake 60/40 index was down 4.6% in January, one of its worst performing months in recent years. As a result, an equity hedge like AGFās anti-beta strategy may help offset some of these losses.
What about positioning within an asset class like equities? A few high-profile, widely held stocks have been sold off in dramatic fashion this earnings season.
Asset allocation is only part of the equation. Some investors may also need to spend more time re-positioning within each of the main asset classes than might be the case in a less volatile climate. On the equity front, there has already been a substantial rotation out of long-duration growth stocks whose future earnings ā if any ā are highly susceptible to rising rates. And with many of these names now trading at much more reasonable valuations than they were heading into the year, that could set the stage for the inevitable rally higher.
Even so, the eventual upswing wonāt likely be fueled by the same degree of speculation that has largely defined equity markets over the past two years. If anything, the āSpec Techā trade that resulted in unreasonable valuations for many technology firms may be starting to give way to an emphasis on growth companies with quality characteristics like clean balance sheets, free cash flow and strong earnings profiles that can withstand the rigors of tighter monetary and fiscal policy, leading to subdued economic activity. To that end, some of the most profitable big-tech names have been hit especially hard this earnings season because of unexpected earnings misses or weak guidance about their future profit growth, which has undermined the rich trading multiples theyāve amassed in recent years.
At the same time, value-oriented cyclical stocks should be considered in a similar vein. While they have outperformed their growth counterparts almost en masse so far this year, it is the higher-quality cyclical names that are likely to benefit more going forward. All in, investors need to be thoughtful about what types of companies they want to own given the heightened volatility thatās at play.
When might investors expect a return to more run-of-the-mill volatility in markets?
There may be some periods of relative calm in the weeks ahead, but itās going to be tumultuous for as long as there are doubts about the plans of several central banks including the U.S. Federal Reserve to tighten monetary policy and ward off inflation. The biggest fear is that they will tank their respective economies by raising rates too aggressively. There are already signs that economic growth is beginning to wane in the United States, for instance, yet the market is predicting as many as eight increases this year and next, starting, some believe, with the possibility of a 50-basis point hike in March.
Of course, the Fed hasnāt committed to that many increases. Its ādot plotā forecasts only three rate hikes this year and while one of those is almost definitely going to happen in March, some Fed officials have spoken cautiously in more recent days about what might come next because of the uncertain outlook for inflation and the ongoing pandemic. Then again, itās partly this disconnect that makes investors so jittery.
And if that isnāt enough, itās important to understand that the market isnāt just concerned about the Fed making a mistake regarding interest rates. It is also deeply worried about the prospects of a reduction in the U.S. central bankās US$9-trillion balance sheet, which the Fed says it will start doing later this year yet has been short on details to date. Remember, the expansion of the Fedās balance sheet through quantitative easing over the past decade has been a huge liquidity boost to the equity market and may be the single most important catalyst that has driven stocks higher throughout this period. Therefore, quantitative tightening could have the opposite effect and end up being a risk on par with a rise in interest rates that ends up being too aggressive.
If anything, then, there should be no doubt that equity markets will eventually rebound from the current correction and it still seems likely that they can end 2022 higher than they were to begin the year. But that doesnāt mean investors are necessarily through the worst of it. Heightened market volatility is also here to stay, likely for as long as the threat of higher rates and the run-off of central bank balance sheets remains uncertain and their impact on future growth prospects is not fully understood.
Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Limited. He is a regular contributor toĀ AGF Perspectives.
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This post was first published at the AGF Perspectives Blog.
