by Jeff Blazek, CFA, Co-CIO, Multi-Asset Strategies, and Erik L. Knutzen, CFA, CAIA, Co-CIO, Multi-Asset Strategies, Neuberger Berman
The current situation is unusually difficult to model, and that reinforces the first principles of investment: know your objectives, diversify and rebalance.
At the start of last week, the VIX Index of stock market volatility, a key indicator of investors’ uncertainty, hit levels unseen outside of the Global Financial Crisis (GFC) and the Covid-19 pandemic. But compared to those two prior crises, in some ways, the current situation is the more unpredictable: as the extreme and sudden changes to U.S. trade tariffs on April 2 and April 9 vividly demonstrated, the dispersion of potential outcomes is arguably wider and assigning probabilities to them is harder.
While such circumstances can be trying, they underline the importance of sticking to key principles of long-term multi-asset investment that can serve as a steady foundation to help mitigate the emotional toll of market shocks.
Modellable Frameworks
After the GFC, it took many years for equities to recover to their pre-crisis levels given the severity of wealth destruction and the substantial debts that had to be restructured (and in many cases, written off). As the crisis was studied in subsequent years, debates ensued about the tradeoff between moral hazard and maintaining financial system stability; over time, economists would scrutinize the size and efficacy of required monetary and fiscal responses during and after the GFC to understand how to better manage economies and markets during a massive systemic deleveraging event.
Market stresses around Covid-19 played out more quickly, and were “v-shaped” in recovery. At that time, there was heated debate about the appropriate trade-off between public health and economic activity, but once this was settled, the major remaining questions were how long it would take to develop an effective vaccine and how deeply our consumption, working and living habits had been changed. Big questions, for sure, but they gave investors widely accepted and “modellable” frameworks.
Volatility has also been triggered by contentious policy decisions, but in such instances the environment has usually been more predictable and modellable than it is right now. Once the Brexit vote was determined, for example, the probability of the U.K. staying in the European Union was virtually zero. Investors could model the three of four different flavors of Brexit available and price accordingly as the choice became clearer.
To put it another way, past episodes of economic fallout and market volatility were caused by the build-up of financial excesses or structural economic problems, or by massive and irreversible exogenous shocks. The current volatility is due to policy decisions that appear loosely anchored and liable to change rapidly.
On April 2 tariffs were announced at rates that sent us back to levels last seen during the global trading situation of the 1930s. And then unexpectedly on April 9, tariffs were abruptly dialed back for 90 days—based on the policy assessments of a handful of people in the White House, perhaps in response to a tremor in the Treasury markets. The situation could begin to settle down, or even improve further, through the coming weeks of negotiation. Then again, volatility could spike once more if a trade war escalates between the U.S. and China, or if talks with countries start to falter.
Fundamentally, when the approach of the U.S. administration can change direction with very little notice, it creates a challenging environment for investors, let alone the countries that are being asked to negotiate. This results in volatility to both the downside and upside—like the $4tn added to the S&P 500’s market cap last Wednesday. And these wild ups and downs appear to bear no relation to what would usually be market-moving data releases, like the surprisingly favorable U.S. jobs and inflation data that were largely ignored on two negative days for the equity market.
So, should investors position for a severe global recession inflicted by negative tariff outcomes or for a strong environment of growth recalling the “Trump-trade” optimism of November last year?
First Principles
The answer, in our view, is neither. Market volatility and significant drawdowns should not cause investors to abandon consistent investment strategy. Challenging conditions like these remind us to refocus on the first principles of long-term multi-asset investing.
First, stay focused on your own investment objectives rather than what the market is doing. Your objectives should determine your return requirements and risk tolerance, and monitoring performance against those objectives can provide early warnings of overexposure: for example, in the weeks and months leading into April 2, prolonged outperformance against your objectives should have been as much of a red flag as prolonged underperformance.
Second, balance your exposures. Most investors will have objectives that are best met with a multi-asset mix. Remember to use the full toolbox: in equity portfolios, broad size, style and factor exposures can create a robust risk profile; allocations to government, investment grade corporate and high yield issues with varying duration can do the same in fixed income.
Illiquid investments can often generate higher returns as well as removing the temptation to trade too much, while assets that are intended to be uncorrelated with stocks and bonds can provide optionality when markets go into crisis. Options-based strategies can play this role, as can global macro and other trading-oriented hedged strategies—consider diversifying these, too, as not all of them will be uncorrelated in every environment. Insurance-linked strategies are another candidate, as natural catastrophes follow their own seasonal and natural event-related cycles rather than the economic cycle or investor sentiment.
Third, rebalance. You set a balance to avoid taking big bets, so take steps to ensure you don’t end up taking big bets by accident: set limits to any deviation from your strategic asset allocation so that you can reassess whether to return to it when those limits are met.
Rebalancing disciplines an investor to buy more of whatever is cheapest in their portfolio. Buying at cheaper valuations is not a guarantee of superior subsequent returns, but it has generally raised the probability of a more positive long-term outcome, all else being equal, especially when investing after substantial equity market drawdowns. Having profits to take and liquidity to draw on, combined with a clear long-term objective, is the best way to ensure that you are ready to take opportunity when market prices dislocate, in our view.
Whatever the Future Holds
Where might that opportunity lie today?
Our latest Asset Allocation Committee Outlook is on its way, and we will be upgrading our view on global equities to overweight, based on the recent equity market correction and our belief that the U.S. tariffs announced on April 2 and modified on April 9 will be subject to further downward revision.
The overweight to global equities reflects a continued positive view on higher quality U.S. small and mid-caps, and an upgrade for non-U.S. developed market equities. The former have been particularly hard hit by the tariff fallout, but we still anticipate catch-up as equity market leadership continues to broaden beyond U.S. mega-cap tech stocks. We think the latter stands to benefit from the big change in Europe’s fiscal policy.
Could there be further downside ahead for equities? Very easily—the radical uncertainty we have described above hasn’t gone away. However, because those who followed the first principles of long-term multi-asset investing should be able to add to their equity allocation now, rather than being caught overexposed on April 3, their likelihood of a positive outcome in three or five years’ time should be considerably higher, whatever the future holds.
