Still Risk On for 2018, Exercising Caution as Tail Risks Loom Larger
Published September 12, 2017
Moving into the final stretch of 2017, we are beginning to look at what 2018 might bring. Global growth could surprise to the upside, especially outside the US, but valuations are high and tail risks on the increase. Despite this, we believe investors can still make money by moving down the capital structure, while also considering whether to hedge against short-term pullbacks.
Growth May Surprise to the Upside
So far, global economic conditions have remained in that Goldilocks fairy tale state of not too hot, not too cold. US growth has been running at around 3% in the second quarter, on track for a similar pace in the third quarter before trending down to 2% in early 2018.1 Nevertheless, we believe global growth may surprise to the upside next year, especially outside the US. Continental Europe and possibly Japan could well benefit further from economic recovery, which in turn would support emerging markets (see Figure 1).
Tail Risks on the Rise
Despite this outlook for stable, positive growth, tail risks have been rising on geopolitical uncertainty, extended equity valuations and tougher earnings comparables. Aside from the binary outcomes presented by North Korea’s sabre rattling and the muddle over Brexit, the drama coming out of Washington, DC, continues. Hurricanes Harvey and Irma have changed the dynamics of the US debt ceiling debate, with a deal agreed to defer the deadline and fund disaster relief now. This will prevent a federal government shutdown at the end of September, but US legislators will still have to wrestle with raising the debt limit in the fourth quarter, while also trying to pass a budget that could include controversial tax reforms.
So in this more uncertain environment, where should investors hunt for returns and how should they manage the emerging risks?
Where to Find Potential Returns
We believe investors can still make money by tilting to equities in developed markets outside the US. Even if parts of the market look expensive, especially the US, we can still find opportunities in other equity markets as well as among lower quality, high beta companies that can benefit from further economic recovery (see Figure 2).
Our fundamental equity team anticipates global earnings growth averaging 6% to 8% in 2018, below the consensus of 9.5%,2 but high enough to support areas that have yet to re-rate. Growth prospects are also still favorable for firms capitalizing on long-term trends such as demographic shifts in healthcare and the internet of things in technology.
Certain value stocks may benefit from central bank actions — for example, financial earnings may see some upside from higher interest rates. In our view, given the effect of subdued inflation expectations on the yield curve, the US Federal Reserve is likely to stay on a gradual, data-dependent path. Financials in Europe have the advantage over the US of being earlier in the rate cycle, since the European Central Bank may start to taper quantitative easing but not raise rates in 2018. They could experience more volatility when stricter capital requirements are implemented, however, so we think investing in low beta now will require a long-term view.
Income seekers face especially tough conditions as we approach the later stages of the credit cycle. Typically the risk-free rate would be higher by now. So fixed income investors may have to take more risk to achieve the returns they need — going lower in the capital structure, while investing less to limit risk exposure. We favour spread products over investment grade. Asset-backed securities, high yield bonds, emerging market debt and leveraged loans still offer relatively attractive opportunities for carry, although next year’s fixed income markets could start pricing in quite different conditions for 2019.
Ways to Seek Portfolio Protection
In such ambiguous market conditions, downside risks may have low probability, but would have high impact. So investors worried about short-term, sharp pullbacks or the resurgence of inflation may want to consider protecting their portfolios using one of these methods:
- Reducing exposure to higher volatility assets and diversifying into commodities or gold can make the overall asset allocation more defensive in case market conditions suddenly reverse.
- Holding more cash may keep the portfolio nimble, as liquidity can become more important.
- Adding products such as floating rate notes and TIPS3 can help protect against inflation, valuation and default risk on the fixed income side.
- Hedging with put spread and put spread collar options4 may have an upfront cost but could play a role in protecting against a downturn given the limited sources of growth and potential tail risks we see now.
Each form of protection has different advantages and costs — not least the possibility of temporary underperformance. At the moment, we find that options hedging can be attractive from a cost/benefit perspective, but the preferred approach is highly dependent on the precision of the hedge and the level of protection desired, as well as the ability and willingness to bear explicit and opportunity costs. So investors will need to assess which method best suits their objectives and time horizons.
1Source: SSGA Economics as of July 2017.
2Sources: J.P. Morgan Securities, IBES, MSCI, Datastream as of September 2017.
3Treasury inflation protected securities (TIPS) protect investors from the negative effects of inflation because the par value rises with inflation, while the interest rate remains fixed.
4These options combine short (or covered) calls and long (or protective) puts to hedge against moderate security price downturns, without excessively limiting upside potential.
The views expressed in this material are the views of Chris Probyn, Esther Baroudy, Matt Nest and Frédéric Dodard through the period ended 9/5/2017 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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