Five new year resolutions to weather market turbulence

All the best New Year’s resolutions are made half-way through January, once you have seen other’s pledges fall by the wayside and you have had time to take a measured look at things and work out what is achievable.

This year began with a nasty hangover in financial markets. Some indices have recorded the worst start on record. While we cannot pretend to have a crystal ball, we have been preparing for a more challenging environment for a while. For the coming year, we have five resolutions that we will put into action to weather this turbulence.  

Our first resolution is to set return expectations low and to lower them as the cycle elapses. Most assets – apart from segments of the credit market and emerging market assets – are not cheap, and consequently forward-looking returns are likely to be below long run averages. As well as this, the current economic cycle has already been quite long. It is true that bull markets do not die from old age, but there are risks on the horizon. The main engine of global growth in recent years, China, has slowed down and is muddling through a difficult rebalancing act. The second driver of growth, the US, is reaching the tail end of its economic cycle. We see the likelihood of the next downturn increasing over time.

Our second is to look beyond traditional assets – even more so these days. For example, risk parity has been all the rage, but we do not believe it provides adequate diversification. This is because equity bond correlations are unstable, and the likelihood of equities and fixed income selling off at the same time is higher when the Fed is tightening monetary policy. To build truly diversified portfolios, non-correlated assets, particularly in times of broader market turbulence, are inherently valuable. We believe certain types of hedge funds can be useful, but it is worth understanding the sources of their returns before taking the plunge.

Next, we pledge to learn to stop worrying and love the volatility. Less banking sector intermediation as a consequence of post crisis regulations has led to changes in market structure, leading to opportunities in direct lending and less secondary market liquidity. The latter has meant that we are seeing more flash crashes and quite dramatic swings in markets that are even more non-normal than usual. These unchartered waters mean that long volatility and gamma hedge fund strategies are useful tools to have at your disposal.

Emerging markets may test our resolve this year – so our fourth resolution is to approach them carefully. Value investing has two main ingredients: to be patient and to buy when everyone is selling. We have been eyeballing emerging markets for quite some time after being consistently underweight for the last few years.  But valuations, particularly in FX, are starting to look interesting. The issue with the categorisation of emerging markets is that economic cycles have become disparate and it no longer makes sense to think about emerging markets as a single homogenous entity. Fundamentals such as balance sheet structures, governance, and exposures to China and to commodities are very different. The fact that emerging markets still tend to get tarred by the same brush leaves opportunities for targeted exposures. Meanwhile, we are still preparing and patiently waiting for the time when emerging market beta becomes more attractive.

Finally, while the debate has increasingly centred on fees, we have turned our attention to reducing costs. We have used cheap passive instruments as the default option in competitive markets and are constantly raising the bar when screening for active managers. Where we have been able to add significant alpha is from manager selection in alternatives. Costs there have been rather sticky, but are slowly coming down and there are opportunities to improve the value proposition for our clients without sacrificing quality.

Ian Barnard is founding partner at Capital Generation Partners