By Edward Park, Investment Committee Director, Brooks Macdonald
Here we focus on the global macroeconomic cycle, the risk of “mini bubbles” and some of our current investment themes, and how to incorporate these broader factors into portfolio construction in order to limit the impact of potential volatility while still participating in market gains.
2017 was a strong year, with 38 out of 39 asset classes monitored by Deutsche Bank generating positive returns. Volatility was low, markets shrugged off geopolitical risks and corporate earnings were robust. Although the US Federal Reserve (the Fed) began to raise interest rates, the gradual path followed and the use of statements and guidance to prepare markets for changes staved off any unexpected actions.
2018, however, marks a change in the tide. During 2017, the Fed broadly maintained the size of its balance sheet (despite raising rates), but in 2018 it has begun taking active steps to reduce it. As shown in Figure 1, when the Fed balance sheet shrinks, volatility increases. Additionally, the European Central Bank has halved its quantitative easing programme, and is signalling that it will stop entirely by the end of 2018. As a consequence, markets have been more aggressive in 2018, and we anticipate that this volatility is here to stay.
Figure 1:
The economic cycle
The market is giving classic signals of being in the latter stages of the economic cycle. Bonds are underperforming, inflation is becoming a worry and there is an increasing risk of market “mini bubbles”. With reference to the Economic Clock in Figure 2, the US is the furthest along in terms of the economic cycle, while the emerging markets and Europe still have some way further to travel, and therefore slightly more capacity. Being in the late stages of the cycle does not mean that there are no investment opportunities to be had, but it does mean that we will look for them in different places, and adjust the amount of risk in our portfolios accordingly.
Mini bubbles
While we do not believe that the broader market is in full-blown bubble territory, we do think there is an increased risk of isolated mini bubbles. These mini bubbles tend to be particularly attractive to and dangerous for retail investors who feel that they have missed out on recent market gains. Some of the signs of such bubbles are increased media focus hype around new, untested industries or technologies. The classic bubble was the technology bubble of the 1990s, where investors piled into not only untested technologies, but more importantly untested companies – a savvy computer scientist does not necessarily make a good company CEO. Even at current valuations, we do not think the tech sector as a whole is in bubble territory, but a number of technology applications may form mini bubbles for over-enthusiastic investors. These could emerge in areas like crypto currencies or peer-to-peer lending. Taking these two together as an example, both are touted as having the potential to disrupt traditional banking using new technology and are, on the surface, compelling. Nevertheless, neither have yet made meaningful strides – Bitcoin attracted a lot of attention when futures in the crypto currency were listed on the Chicago Mercantile Exchange, but the value has been extremely volatile and the market remains untouched by leading financial institutions.
Liquidity risk
Banks have improved their risk positions since the financial crisis of 2007-2008, a move which has been enforced by more stringent regulation on the amount of capital they have to keep on hand. While this is good news for financial stability, it is not necessarily such good news for global markets: banks used to be the buyers of assets when no-one else would touch them, but now, these same banks are far less willing to take on assets that have become hard for others to sell. The result is a restraint on market liquidity and during economic shocks when illiquid asset trades dry up, valuing the assets becomes problematic. As a consequence, in our portfolios, we have been selling down some of our less liquid assets, and looking very closely at the trade-off between risk and return.
Investment themes
We believe that using investment themes that look at broad industry or demographic trends can be an effective way of seeking returns against a more volatile backdrop than more traditional portfolio management techniques of, for example, using geographic exposure or investing by market cap. Edward introduced two themes, technology and financials, and explained how they work together to target investment returns while also protecting against volatility.
Technology
Technology has been a top-performing asset class for the US, despite recent jitters surrounding data usage. In contrast to the time of the “tech bubble”, major technology companies are now earning strong revenues and returning cash to shareholders, and the sector as a whole has outperformed the broader market in recent years. We believe there is still significant room for long-term growth. Technology as a sector is valued on the basis of its future cash flows, reflecting the fact that with innovative products, profits will filter through in the future rather than being immediately available now. Valuing an asset on the basis of future cash flows means that a discount rate is applied to bring those cash flows back to their value today. The lower the discount rate, the higher the present value. Technology therefore tends to do better in low-rate environments – if interest rates go up and the discount rate used for valuation increases, the future cash flows are divided by a bigger number and the present value drops.
Financials
In contrast to technology, financials tend to do better in a rising interest rate environment, because financial institutions benefit when the difference between short and long-term rates is higher, enabling them to profit from their lending activities. The financial sector is also enjoying greater stability following implementation of the more stringent capital requirements for solvency following the financial crisis.
Conclusion
Blending themes, such as financials and technology, which have contrasting features and tend to perform well in different economic environments, is one way in which we seek to benefit from market gains while protecting against broader market volatility. It also aids portfolio diversification and risk management, as detailed analysis of investment themes uncovers hidden risks, as well as investment opportunities.
As the macroeconomic cycle continues to turn, we believe there are still investment opportunities to be found, but that investors need to be more mindful of the risks posed by mini bubbles and lower liquidity in markets. Through appropriate diversification and seeking out longer term investment themes, we aim both to position and protect our portfolios for the potential volatility ahead.
For further information contact Peter Musker, Business Development Manager, Brooks Macdonald International +44 (0)1534 715 575 or peter.musker@brooksmacdonald.com
Important information
The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the firm.
This article is intended for professional advisers only and is not intended for use by retail clients. While the information in this article has been prepared carefully, Brooks Macdonald gives no warranty as to the accuracy or completeness of the information.
The performance indicated for each sector should not be taken as an expectation of the future returns. Investors should be aware that the price of investments and the income from them can go down as well as up and that neither is guaranteed. Past performance is not a reliable indicator for future returns. Investors may not get back the amount invested. Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Investors should be aware of the additional risks associated with funds investing in emerging or developing markets.
The information in this document does not constitute advice or a recommendation and you should not make any investment decisions on the basis of it. This document is for the information of the recipient only and should not be reproduced, copied or made available to others.
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