Trump. Brexit. There were plenty of big stories last year. But the one that may matter most for your portfolio in 2017-and how you manage risk-is how markets responded to these surprises.
How to sum up that response? Maybe this: it took markets three months to process Japan’s negative-interest-rate policy, three weeks to get over the Brexit shock and about three hours to digest Donald Trump’s election (Display 1).
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In each case, global stock markets and other risk assets initially sold off, only to recover swiftly—a trading pattern known as a V-shaped recovery for how the price move appears on a trading screen.
This kind of highly correlated trading, with risk assets moving in one direction and safety assets (such as government bonds) in another, isn’t new. As any investor active in recent years knows, risk-on/risk-off has been a recurring pattern in markets since the global financial crisis.
For investors, keeping pace with abrupt shifts in risk sentiment has been a challenge. For instance, when risk aversion spiked, investors typically tried to sell equities. But it’s been hard to get the timing right. Often, stocks would start to rebound just as investors were starting to sell. Being late to join the recovery, of course, would hurt portfolio returns.
Changing the Investment Playbook
But what if this risk-on/risk-off pattern is breaking down? The risk-off periods certainly appear to be getting shorter. We think there are explanations for this. First, global growth is finally starting to gain traction—good news for many growth-sensitive risk assets, such as stocks and high-yield bonds.
Related to this, developed markets are moving beyond a singular reliance on monetary policy to boost growth. Japan is supplementing ultra-loose monetary policy with fiscal stimulus, and the US may soon do the same. As a result, risk-on/risk-off trading patterns may be fading away, to be replaced by trending markets.
What does this mean for investors in 2017?
For one thing, it changes the way they need to think about risk and return. Investors will want to be open to a wide range of market signals so they can decide which ones most accurately reflect the conditions of the day.
Momentum and volatility, for example, may become important factors driving stock markets again. These factors were less important—and often misleading—when risk-on/risk-off prevailed, but that may be changing.
And it pays to examine each signal carefully. As Display 2 illustrates, actual stock market volatility is unusually low today. But that doesn’t necessarily mean we’re in for a long, tranquil period. Other measures, such as the spread between implied and actual volatility, tell a different story.
Don’t Forget to Diversify
We think investors should also diversify their portfolios and be willing to capitalize on relative-value opportunities as they emerge.
If we’re entering a period of reflation—or renewed inflation—and moderately faster growth, investors will want the ability to move seamlessly across asset classes and regions into areas best positioned to benefit from higher prices. These might include commodities, currencies or select emerging markets.
A holistic, multi-asset strategy allows investors to pivot quickly to seize these types of opportunities. A narrow focus on a handful of assets—split into many different silo-liked strategies—makes doing that harder.
Why Autopilot Won’t Fly in 2017
There’s something else to keep in mind, too. If markets are entering a new period in which assets trade based on their own merits rather than on what central banks do, a hands-on approach will be essential. If the era of risk-on/risk-off is fading and longer-lived trends are starting to form, investors may be tempted to put their portfolios on autopilot, thinking they can stay afloat just by going with the flow.
We think that’s a risky approach. Even in trending markets, there’s always the possibility of an expected disappointment or a big sell-off.
This year could bring new surprises that upend the current growth trajectory or policy outlook. Investors are still facing plenty of uncertainty. Will Britain negotiate a smooth exit from the European Union? Which policies will Trump prioritize—and which will he get through Congress? Will French and German voters opt for antiestablishment leaders of their own in elections this year? The ability to adjust allocations quickly will be key.
Habits can be hard to break. All of us are coming into 2017 with a set of beliefs about how markets react that’s been formed over the past five years of market activity. Those beliefs may not be relevant anymore. That calls for an investment strategy that’s flexible, with a broad approach toward risk and return and how they fit together. If we’re at an inflection point, investors will want a portfolio that can adapt.
In markets, as in life, the only thing that’s constant is change.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Article by Martin Atkin – Alliance Bernstein