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What’s next for markets and how to control risk

We are aware that we have discussed risk on a number of occasions in these commentaries but in our line of work, it is a very important issue and one we have continually to consider.

stopping risk the wooden blocks from falling

by
Simon Martin

10.06.2020

We all face risks every day—whether we’re driving to work, surfing a 60-foot wave (I know that happens a lot in Yorkshire), investing or managing a business. In addition, over the past few months we have also had to face risks to our health, and the economy faces a risk of a further downturn if we see a second wave of infections as we move out of lockdown.

March was probably the worst market conditions I have ever seen since I started working in 1987. As you can imagine, this time horizon included the 1987 crash, 9/11, the dotcom crash and the 2008 crash. But in March the speed that all assets became highly correlated and fell was unprecedented. Thankfully we have seen a recovery which has helped to reduce investor concerns.

Exposure to catastrophic incidents is certainly a crucial consideration for all investors - whether they be the general (e.g. financial crises) or the specific (e.g. frauds) - but it is not only the extremes that should concern investors. Risks that seem small and inconsequential at any given point in time, can compound to have ramifications that are just as significant. The risk of simply going outside may seem trivial to one person but it could be a major concern for other people. We, therefore, have to consider all types of risks and concerns when we are dealing with clients and especially when we are looking after other people’s money.

When an event such as the coronavirus pandemic hits markets, investor attention is inevitably drawn to the damage that can be wrought by high impact, unpredictable episodes. This is understandable as such occurrences can have significant financial consequences. Yet whilst it is important for investors to prepare for and protect ourselves from these scenarios as best we can, we should not focus solely on the extreme possibility. Also, we have no wish to ever trivialise concerns but we have to look beyond short term issues and focus on the longer-term perspective.

The risk-return trade-off is the balance between the desire for the lowest possible risk and the highest possible returns. In general, low levels of risk are associated with low potential returns and high levels of risk are associated with high potential returns. We work with all clients to consider how much risk they’re willing and able to accept for a desired return. Hence why we continually discuss the suitability of investments in a portfolio and why strategies have to evolve as circumstances change continually.

But it is important to keep in mind that higher risk doesn’t automatically equate to higher returns. The risk-return trade-off only indicates that higher risk investments have the possibility of higher returns—but there are no guarantees. On the lower-risk side of the spectrum is the ‘risk-free rate of return’—the theoretical rate of return of an investment with zero-risk represents the minimum return you would expect for any investment. You wouldn’t accept additional risk unless the potential rate of return is greater than the risk-free rate.

While it is true that no investment is fully free of all possible risks, certain securities have so little practical risk that they are considered risk-free or riskless assets. For example, a U.S. Treasury bond is considered one of the safest investments when compared to a corporate bond. Hence why it provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government and, because the default risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

Unfortunately in March, these ‘risk-free’ and low-risk assets all fell at the same time as risk assets which is why it was such a difficult period to work through.

Fortunately, we have seen a continued rally in equity indices throughout May, building upon the initial recovery seen in April. This has been welcome. One factor causing this recovery has inevitably been FOMO (fear of missing out) and TINA (there is no alternative). However, it is the government support packages that have helped most to protect against further economic damage and dislocation. We have highlighted before that lockdown has caused considerable damage to the UK consumer economy, one that leads to company earnings falling and the subsequent knock-on effect on dividends. The longer-term consequences of this are yet to be seen, but there remains a belief that the rally is “looking through” these factors. When underlying circumstances and trading conditions in Q3 and Q4 become apparent, a better grasp of how far these are reflected in share prices and ratings will be clearer.

Over the last few days, rioting and looting have broken out in many US cities following the death of George Floyd. People have been injured, properties burned and goods stolen. Whilst these events played out, the Federal Reserve (Fed) has quietly got on with its task of supplying large sums of money to markets. The Fed balance sheet rose by $60bn between May 18th and May 25th as it issued more money, extended more credit and accepted more deposits from banks. Its balance sheet climbed to $7.097 trillion, compared to $4.17 trillion in mid-February. There is, therefore, an unprecedented tsunami of money buying up most things, including equities, as it washes through the system and as a result the S&P 500 Index has risen 2% during this new crisis.

What next for markets?

We obviously have to be mindful of a market pull-back if we see a second wave of Coronavirus cases emerging in Asia and, more importantly, here in Europe.  At the moment, with lockdown restrictions easing, we have to expect that there is a high probability of a pull-back at some point. 

Therefore it is important that we stick to our themes and plans to take advantage of this scenario.  Timing such a potential correction and predicting what is going to happen is almost impossible, and there is a danger of trying to obsess with market timing.  So we have to stick with the plans and keep developing the multi decade long themes we have highlighted on numerous occasions.  Even with the market at these levels, it is important that we continue with the transition and the evolution into the new structure in order that we can be best placed to take advantage of any further weakness.

We also have to be mindful of the risk of markets rising too fast.  Buyers of shares are said to be looking through the relaxation of the lockdowns, to the strong recovery in output and turnover that will be seen in businesses that have just experienced a period of no turnover, the chances of a vaccine or treatments emerging which will end social distancing altogether, and now to an early end to the riots.  Markets seem to imply there is only a low probability of a second wave to the pandemic, though major negatives remain.  But we do know that there is going to be a global recession – the depth and duration of which is unclear.

How to control risk

Learning that risks can apply to different scenarios and some of the ways to manage them holistically helps us to avoid unnecessary and costly losses.  An investor’s personality, lifestyle and age are some of the top factors to consider for individual investment management and risk purposes.  Each investor has a unique risk profile that determines their willingness and ability to withstand risk.  However, the most basic – and effective – strategy for minimizing risk is diversification.   A well-diversified portfolio will consist of different types of securities from diverse industries and geographies that have varying degrees of risk and correlation with each other’s returns.

In addition, the consideration of time horizons and liquidity of investments is also a key factor when managing risk assessment and risk management.  

Conclusion

We continue to hear numerous anecdotes, as people attempt to explain why markets have rallied.  In this case, we know why markets have rallied; Governments and Central Banks have effectively written a blank cheque and said they would do whatever it takes to shore up weakened economies. Most global economies are now supported by unlimited quantitative easing which has given investors sufficient peace of mind to go and buy stock. The recovery could, therefore, go on for longer given the fact that Central Banks have made no indication that they plan to stop quantitative easing or tighten interest rates any time in the near future.

As I mentioned in the introduction, March was a very volatile investment environment but thankfully central banks reacted very quickly and effectively drew a line in the sand which allowed credit markets to stabilise and form the foundation from which the recent rally has evolved.  More importantly, it demonstrated that lessons have been learnt and central banks reacted far quicker than they did in 2008/9. 

This, therefore, gives us optimism that even if we experience a second wave, the fact that governments and companies now have procedures in place to deal with moving into and out of lockdown, that testing is established, the global pharmaceutical industry is working on a vaccine and contact tracing apps are becoming available, means that the implications of a second wave may not be quite a bad as we envisaged.  It will obviously have some effect but we have to be mindful that over the medium term, we could see a much quicker recovery. 

We believe that there is still scope for equities to rise from here.  We continue to see evidence that investors are still underweight equities.  While we acknowledge some near-term risks from elevated momentum trader’s positioning on US equity futures, we believe that there is still plenty of room for investors to raise their equity allocations over the medium to longer term.

Finally, we feel that it is still right to realign portfolios towards a growth scenario.  Value strategies have had a tough 10 years.  Growth strategies have beaten value by c80% in the US and by c100% in Europe since the start of 2009; this includes c20% outperformance year to date.  The post-global financial crisis “winners” have kept on winning.  Unlike previous cycles, growth as a strategy has not failed or indicated that it is near the end of the cycle.  This suggests to us that growth could continue to play a lead role in the new cycle.  So, structurally, we continue to like growth but valuation metrics are vital as we control portfolio risks and this supports portfolio rebalancing.

Being defensive has its place in the investor peace of mind psyche, but staying too defensive also carries risk at this point. 

Nothing in this article should be construed as personal advice based on your circumstances.  No news or research item is a personal recommendation to deal. The value of investments can fall as well as rise. Investors may get back less than invested.

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