A funny thing happened after the close of US markets on Wednesday, November 8. With no obvious catalyst, stocks, bonds and credit spreads worldwide went through five trading sessions of the jitters. High yield bonds, which had been weak for some time already, took the brunt of the sell-off. When the dust settled, however, the S&P 500 Index had suffered a dent of barely 1 per cent before buyers re-entered the market.
The “Goldilocks” dynamic, supported by strong fundamentals, reasserted itself, as did the calm we have come to expect from the millpond markets of 2017. The rewards for those looking to “buy the dips” were both scant and fleeting.
When Nothing Looks Cheap
What are the asset allocator’s options when nothing looks cheap and corrections are so shallow and short-lived?
When price-to-equity ratios are high, yields are low, cash rates are almost nonexistent and credit spreads are tight, it is easy to assume that our hands must be tied behind our backs. On what basis can we favour one asset class over another? If corrections are so meagre and the opportunity cost of sitting on cash reserves is potentially so high, what’s the use of a tactical stance?
We do not see it that way.
Our first response is to be clear about the economic context in which we are operating. In short, strong macroeconomic fundamentals and corporate earnings are real; we believe investors should remain exposed to growth.
With that acknowledged, the challenge is to remain exposed to growth in the most prudent way, with the risks skewed in our favour as far as possible.
Relative valuations between asset classes are an important basis for achieving this, but not the only one. Our job is not just about evaluating cash-versus-governments-versus-credit-versus-equity. As the valuations of these different asset classes all increase, in our approach to managing multi-asset class mandates, we see three other options growing in importance.
First, we have the option of comparing valuations within asset classes. Within equities, for example, we can seek out opportunities that are less fully valued, and yet also exposed to potential catalysts for further growth, such as US tax reform or the economic recovery in Europe. That suggests non-U. S. markets or, within the US, smaller, more cyclical companies rather than the large-cap “FANG”-type stocks.
Second, we have the option of selecting the optimal risk/return profile from the corporate capital structure as we retain exposure to corporate growth. That currently suggests a tilt to equities over bonds, at least at the margin. Because corporate bonds pay a fixed coupon, there is effectively a cap on their prices (or a floor to their yields). By contrast, equity prices are ultimately determined by company earnings, and because earnings are not fixed there is no mathematical cap on equity prices. Once equities and bonds reach a certain level of valuation, in other words, only equities still offer meaningful upside risk. For bondholders, almost all the risk is to the downside.
And third, we have options that involve — well, options. We can allocate to strategies that have historically captured more upside than downside from equity markets, with lower volatility. Selling equity index options to harvest the equity volatility risk premium may be one way to achieve this.
New pages in the asset allocation textbook
When valuations appear high everywhere, when it is unclear exactly where we are in a maturing cycle, and when market dips are shallow and short-lived, we need to write new pages into the asset allocation textbook.
Our approach today is less about relative valuations between asset classes and more about finding those asset classes and subsectors where meaningful upside is still available, and then extracting that upside in more sophisticated, risk-controlled ways.
Erik Knutzen, Chief Investment Officer — Multi-Asset Class