Global Asset Tracker: Don’t fear market volatility – plan for it

After the end of the US Federal Reserve’s quantitative easing programme (QE), which has supported the global economy and inflated asset prices in recent years, while keeping volatility and interest rates at record lows, macro-economic and geo-political pressures have reared their ugly heads all at once.

Concerns about China’s slowdown, tumbling oil prices and, more recently, worries about increased US recession risks and prospects of a new banking crisis, have triggered an indiscriminate sell-off in global financial markets since the start of the year.

Market volatility shows no signs of abating, according to PWM’s first annual private banking Global Asset Tracker survey, based on interviews with chief investment officers, heads of asset allocation and chief investment strategists of 35 selected global and regional private banks. Together they manage more than $7.5tn in total client assets globally. 

More than 90 per cent of respondents believe high volatility will be a feature of markets this year (Fig 1). “Fear-driven markets unfortunately suggest that we are going to continue to see near-term volatility,” says Simon Smiles, CIO UHNW at UBS Wealth Management. “And, in this case, volatility begets volatility.”

China’s slowdown is seen as the most important driver of market turbulence (Fig 2). While Chinese authorities are perceived to have the capacity to shift the economy from an investment/export-driven to consumption-focused model, their management of financial markets has raised criticism. Attempts towards liberalisation of equity and currency markets have proven somehow disorganised, generating a crash in Chinese equities and considerable pressure on the yuan. 

“The Chinese outlook may remain somewhat uncertain in the short term, although we believe the government will manage to stabilise growth in coming quarters,” says Willem Sels, chief market strategist at HSBC Private Bank. “But this lag may keep volatility elevated until we see such a stabilisation of economic data.”

The outlook for the oil price remains uncertain too, with concerns on oversupply affecting asset classes around the globe, in particular US high yield, the prices of which have fallen on the back of rapid oil price decline, as shale oil companies’ troubles have pushed up spreads sharply. Although cheaper oil cost benefits consumers, prices have dropped below the threshold believed to be around $40/b – where the negatives in terms of financial disruption start to outweigh the positives, according to Pictet Wealth Management.

The Fed policy on interest rates contributes to leave markets in limbo too. “The Fed lacks a clear model following the end of QE, which creates uncertainty, and other central banks’ QE is too weak to sustain financial markets,” believes Christophe Donay, head of asset allocation and macro research at Pictet Wealth Management. As a result, central banks’ ability to repress financial volatility has decreased, and large drawdowns have become more frequent. “Markets are not yet ready to digest the Fed’s tightening cycle,” he says. In February, Fed Chair Janet Yellen warned that global turbulence could hit US growth, underlining suggestions that a second interest rate increase by the central bank, following December’s hike, has become less likely in the near term. 

EM currencies, especially commodity-producers, have slumped, creating the risk of a financial crisis, most notably in Brazil. Some believe the global equity bull market may be getting closer to the end, as the US economy and business cycle matures.

However, many argue there has been little change in economic fundamentals and the US, the eurozone and China remain on course for a healthy real GDP growth. “Markets are disconnected from underlying fundamentals,” states Mr Smiles at UBS. These include European recovery, a strong US consumer story, and the ability of the Chinese government to sustain the economy transformation, coupled with “continued incredibly supportive”of central bank policies, in particular from Bank of Japan and the ECB. 

“These fundamentals will play out over the course of the year and equity markets will recover,” he predicts.

While this cycle is already one of the longest on record, the US Fed is still focused on supporting growth rather than fighting inflation and US economic expansion may last for at least 18-24 months, notes Alexis Calla, global head of investment strategy and investment advisory at Standard Chartered. “History suggests this is still a good point of the cycle to be invested in risky assets.” 

Nevertheless, investors will need to be even more vigilant. “We would increase allocation to bonds and alternative strategies as we approach the end the cycle, to diversify sources of return and help lower portfolio volatility,” says Mr Calla.

Although the market correction offers interesting buying opportunities, increased volatility is expected to drive investors to reduce risk assets in portfolios, according to two thirds of the respondents (Fig 3).

Diversification is the single most-used technique to mitigate portfolio volatility (Fig 4). “Robust diversification is the balance between risk assets – everything that looks, feels and acts like an equity – and risk control assets, ie high quality fixed income,” says Katherine Nixon, CIO for Wealth Management at Northern Trust. 

She recommends investors have appropriate exposure to highly liquid, high quality fixed income, as this will enable them to manage through volatility and avoiding selling risk assets at distressed prices. “Market volatility is normal, and should be expected, and it is critical for investors not to fall victim to this.” 

Increased allocation to alternatives, both liquid and illiquid, is also key in volatile markets. In a portfolio for a fairly conservative client with a balanced strategy, just slightly below 50 per cent of respondents have a tactical overweight to alternatives (Fig 5). More than three quarters expect clients’ allocation to alternatives to increase over the next 12 to 18 months, with hedge funds leading the way (Fig 6).

“Because of their lower correlation with traditional equity and fixed income markets, alternatives are well suited to a market that will experience higher volatility across asset classes, and investor allocations will increase,” predicts Iain Armitage, regional investments head for Emea at Citi Private Bank. The global bank is particularly positive about opportunities in diversified hedge fund strategies, credit and distressed opportunities in private equity. 

Hedge fund strategies are generally expected to deliver positive absolute returns in 2016, on the back of rising volatility, equity market dispersion, trending markets and policy divergence. 

Increased use of flexible, unconstrained funds, capital preservation and structured products, as well as cash, are also seen as important portfolio techniques in current volatile markets. However, higher correlation across asset classes is a factor to take into account. 

“Lack of trading liquidity in credit markets and increased positive correlation across asset classes, due to central banks’ QE programmes, tend to reduce the effectiveness of tools aimed at mitigating market volatility in portfolios,” says Giuseppe Ripa, head of asset allocation and bond portfolio models for global investments at UniCredit.

Equities are generally expected to outperform bonds for the fourth consecutive year, supported by high single-digit to low double-digit earnings growth, robust global growth and accommodative central bank policies. 

Our sampled private banks, on average, have a strategic allocation of 38 per cent to equities, with more than half having a tactical overweight (Fig 5) by around 7 per cent, on average. 

The large majority believe European stocks are likely to offer the best value or growth opportunity in 2016/2017 and 85 per cent of the respondents ‘walk their talk’ by having a tactical overweight to this asset class (Fig 7 and Fig 8). Around 60 per cent have a tactical overweight to Japanese stocks. Stimulative monetary policies, record low borrowing costs, weak currencies and energy costs are supporting corporate earnings and domestic demand in both Europe and Japan.

“We regard eurozone companies as currently best positioned to benefit from continued global demand,” says Mads Pedersen, head of global asset allocation at UBS Wealth Management, explaining the bank’s overweight to eurozone equities.“Low refinancing costs and a supportive currency effect should additionally support rising profitability.”

Only 20 per cent of respondents view US equities as offering the same level of opportunities, believing the business cycle in the country is at an advanced stage. “Europe is some four years behind the US in terms of profit cycle,” says Oyvin Furustol, head investment services for Europe at LGT. 

“European equities are cheaper than their US peers and we expect better earnings growth and substantially higher dividend yields,” he says. The European recovery is to continue, albeit at a slow pace, supported by ECB monetary stimulus, while the US Fed is stepping back. 

Some other private banks, such as US-based BNY Mellon, make a stronger case for US stocks. “While we believe the dollar will remain strong in 2016, the majority of the upward move is over and this stability should be welcome for large, multinational US corporations,” says Jeffrey Mortimer, director of Investment Strategy at BNY Mellon Wealth Management. 

As the global economy continues to merely “plod along” in 2016, the US’ growth rate may be slightly better than most other countries in the developed world. Also, he says, US financial institutions may prove to be in better condition than their global counterparts, “possessing stronger balance sheets and having been stress-tested more rigorously after the financial crisis of 2007-2009”.

Japanese equities also continue to attract interest, despite strong market volatility. The yen strengthened amid recent global risk-off sentiment, thereby making it even more difficult for the Bank of Japan to reach its inflation target. The BoJ is hence expected to at least maintain, if not expand, its very easy monetary policy stance, according to UBS, which is tactically long USD/JPY.

“Japanese equities remain among our preferred investments for 2016,”says Eric Verleyen, CIO of Société Générale Private Banking. “In the short term, the market is suffering from the global risk environment, but as the situation stabilises and markets reconnect to fundamentals, the Japanese market should exhibit good performance”. 

The government’s programme to improve corporate governance will continue to encourage large companies to implement share buy backs or distribute higher dividends, he says.

According to Ibes consensus, as a result of increased company sales and higher margins, earnings growth in the year to March 2016 is expected to be close to 16 per cent, significantly above the level of other developed markets, and more than 10 per cent for the following year.

While cautiously optimistic on Asian equities, private banks continue to hold a negative outlook on non-Asian emerging markets, due to the weak outlook for economic growth – exacerbated by EM vulnerability to the China slowdown – and corporate profits, primarily due to the continued decline in commodity prices.

Valuations in developed markets are considered high, but not overvalued, and the recent correction provides buying opportunities for European and US shares, in particular European banking stocks. On the contrary, valuations in emerging markets are believed to be attractive, but catalysts for a broad re-rating are perceived as elusive. EM equities earnings and profit margins are expected to continue to deteriorate, against a backdrop of weak domestic fundamentals.

As a consequence, the majority of private client money is likely to flow to Western Europe, Japan and the US over the next 12-18 months (Fig 9).

But over the longer term, the outlook may change. Charles Nogueira Ferraz, CEO Brazil at Itaú Private Bank invites investors to be “alert for opportunities in emerging markets later in the year”, as EM equities will eventually bottom out. “Over a three to five-year period they could be one of the best performing asset classes.” 

The average strategic allocation to fixed income is 43 per cent, but almost three quarters are tactically underweight (Fig 5). There is a clear preference for high yield bonds (Fig 7), with more than 60 per cent having an overweight to this asset class, while government and high grade corporate bonds are seen as offering little value or growth opportunity (Fig 11).

Northern Trust remains “significantly overweight” to high yield credit, seeing limited contagion of default risk outside the energy/commodity names. “Current yield to worst provides very attractive risk/reward for high yield,” says Northern Trust’s Ms Nixon.

“The eurozone high yield issuers have been penalized by the recent risk re-pricing in the US and the current level of yield spreads is attractive,” states Luc Lefer, global head of discretionary portfolio management at BNP Paribas Wealth Management, which has a tactical overweight on European high yield.

At an average yield to maturity of 6.3 per cent, euro high yield bonds offer “an appealing yield pickup over ‘safer’ bond segments”, according to UBS, which has a high conviction call on this asset class. At the same time, the credit quality of euro high yield bonds is relatively good, with two thirds of the index rated ‘BB’. Unlike its US counterpart, the euro high yield index has a relatively small exposure to the energy sector, of around 5 per cent, and default rates are expected to remain below 2 per cent through 2016, versus 5.5 per cent in the US. 

High grade bonds, on the contrary, are unlikely to deliver attractive total returns over the next six months from current low yield levels, according to UBS and the majority of banks.

Some institutions hold different views. “We recommend clients have an overweight position to investment grade corporate bonds in the US, due to attractive spreads and solid credit fundamentals,” says Leif-Rune H. Rein, chief investment strategist for Norway at Nordea. 

Investment grade corporate bonds have been less affected than other equity-correlated assets, according to Pictet, and investments in this asset class allows avoiding negative interest rates on cash, in both euros and Swiss francs.

The panel is divided over the level of risk-adjusted portfolio returns to expect for this year, compared to 2015, although the relative majority is optimistic (Fig 10). “We expect absolute returns to improve over 2016, as markets come to terms with oil/China fears,” says Alan Higgins, CIO at Coutts. “However, risk-adjusted, returns will be challenged, reflecting the high degree of market volatility.”

Even if lower, this year’s risk-adjusted returns will still be “rewarding in a low inflation, low interest rates environment”, says UniCredit’s Mr Ripa. 

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Banks participating in PWM’s global asset tracker:

ABN Amro Private Banking, Banca Generali, Bank J. Safra Sarasin, Bank Vontobel, Banque SYZ, Barclays Wealth and Investment management, BBVA Private Banking, Berenberg, BNP Paribas Wealth Management, BNY Mellon Wealth Management, BTG Pactual, CA Indosuez Wealth Management, CaixaBank, Citi Private Bank, Coutts, Credit Suisse, Deutsche Bank PWM, Erste Private Banking, Fideuram-Intesa Sanpaolo Private Banking, HSBC Private Bank, Itaú Private Bank, KBC Private Banking, LGT, Lombard Odier, Nordea Private Banking, Northern Trust, Pictet Wealth Management, RBC Wealth Management, Santander Private Banking, SEB Private Banking, Société Générale Private Banking, Standard Chartered Bank, Union Bancaire Privée, UBS Wealth Management, UniCredit Private Banking