Investment Insights: Why Diversify Now?
Volatility re-emerged globally in 2018. Although equity markets enjoyed a strong start to last year, uneasiness continued to seep into the markets as the year continued. There was no shortage of drivers for the uptick in volatility, ranging from concerns over a global growth slowdown, rising interest rates, increased trade tensions and continued geopolitical uncertainties. Against this backdrop, global equity returns turned negative in the fourth quarter of 2018 as the MSCI World Index declined by 8.4%. After a seismic drop of almost 6% in October, global equities recovered in November before plummeting again in December. In this economic climate, we firmly believe the case for diversifying institutional portfolios is stronger than ever.
As a quick reminder, the aim of diversification is to minimize portfolio volatility by spreading a portfolio’s asset mix across a wide range of asset classes with differing drivers of return and imperfect correlations. From a volatility perspective, since the 2008 recession, portfolios that were well diversified have generally benefited from lower levels of volatility relative to portfolios that were less diversified. From a performance perspective however, this also meant that well diversified portfolios underperformed portfolios with higher concentrations to equities, as these portfolios were able to take full advantage of accommodative central bank policies which helped launch global equities to a near-decade long run of dominance following the economic recovery.
In this note, we explain why today’s economic climate presents an opportune time to re-evaluate the systematic risk that portfolios with only traditional asset classes contain. We then propose alternative asset classes as diversifiers whose inclusion can help reduce portfolio volatility, followed by an introduction to liquid and illiquid alternative asset classes clients can consider implementing.
In September 2018 we noted that the markets had moved into a ‘transition’ environment. Our belief was based on market conditions at the time which indicated a transition from a near-decade long period of risky asset strength towards an inevitable market downturn that would be characterized by a flight to quality. Although we do not believe such an economic downturn is imminent, the entry into a transition environment is significant because it reflects the reality of changing economic and tighter financial conditions.
Over the last ten years, equity and credit markets have generally performed well. Moving forward, we now expect that both equity and credit markets are likely to face more volatility with the potential for steep sell-offs. The chart below shows that equity markets have continued to advance steadily higher as economic growth and earnings have driven returns throughout much of the last decade. At the same time, many bond markets are still expensive as yields have fallen over recent years on the back of quantitative easing and global monetary policy (Canadian and U.S. government bonds are an exception, as their yields have risen substantially over the past three years).
Given the decade-long rally in both asset classes, valuations remain high and have become increasingly dependent on positive news flow, which in current times is far from guaranteed. Although risky assets have been expensive for quite some time, other headwinds are now mounting in addition to valuation concerns. This expanded set of challenges includes rising interest rates, as highlighted by the U.S. Federal Reserve’s decision to increase rates in December for the fourth time in 2018 and ninth time since 2015. A rise in global populism has muddied the trade waters, with protectionist stances threatening to jeopardize long-standing trade agreements after decades of embraced globalization. In recent years, we have seen decisions such as Brexit, the re-negotiation of NAFTA (CUSMA) and most recently, trade negotiations between the U.S. and China dominating headlines.
Continued market sensitivity to news flow and data releases would imply further surges in market volatility are entirely possible, especially as corporate earnings start to lose momentum in an environment of slowing global growth. Last year’s rise in volatility was best illustrated by a tripling of the CBOE Volatility Index (VIX) twice in 2018; first in February and then again in mid-December (see chart below).
In recent years, equities were well supported by relatively low bond yields as interest rates were at or near historic lows. In today’s rising yield environment however, market sensitivity to upward rises in interest rates remains a key risk. And, as volatility continues to enter the markets, we cannot discount the possibility that both equity and bond markets may fall at the same time, making the need to expand diversification efforts beyond traditional investments more critical than in previous market cycles.
Looking ahead, our outlook for several key asset classes are more muted for 2019 and beyond. In our view, we are likely to see flattening underlying price trends in risky assets with alternating cycles of optimism and pessimism, changes in market leadership, higher volatility and less conviction in returns. While we do not believe an economic downturn is imminent, we do believe that preparing for more difficult market conditions moving forward is warranted.
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