Downgrading Equities and Portfolio Implications

Summary

• We are downgrading our global equity view. Equities now move into the negative region of our medium-term view heat map.

• This does not signal an imminent end to what we have seen as ‘transition market’ conditions. The downgrade to negative in our heat map (1st notch), rather, signals that sustained gains are now hard to achieve, and risks are rising.

• The transition market conditions over the past year have produced numerous volatility spikes, but the bull market is still mostly intact.

• This is now the longest US bull market on record, no doubt helped by the current economic expansion also turning into the longest ever too. The growth in corporate profits in the US has been extraordinary and ultra-low bond yields have boosted investors’ risk appetites, all of which have helped.

• However, market support has been ebbing in the past 12-18 months, reflecting a sag in economic growth momentum as well as signs of pressure on profits. These concerns look likely to stay with us or intensify.

• Central bank rhetoric and the possibility of a temporary truce in trade conflicts could easily take the markets higher still in the near-term. However, fundamentals are unsupportive of further gains being sustained.

• Given the equity downgrade, we look at a range of areas into which de-risked funds from equities can be directed. We look at which have strategically diversifying attributes and where the return outlook is still reasonable.

• We believe that a combination of government bonds, non-directional hedge funds/alternative risk premium funds, direct real estate, direct infrastructure, cash, and perhaps gold, should feature in diversifying away from equities.

A still largely intact bull market

It might feel as though equity markets have been weak seen since early 2018. Volatility has tended to be higher with several big spikes. However, the market numbers tell us that this is still a largely intact bull market. Even after the numerous setbacks seen over this period, including in May 2019, at the time of writing, we are very close to or at new highs for US and global equity market benchmarks.

Bull markets compared

Looking back over a dozen such bull markets spanning nearly a century and using the US as our guidepost for the moves in global equities, the only competitor to the current bull market, using length as the yardstick, has been the 1990s. The current bull market span, over 10 years long, has eclipsed this competitor. We do remain a bit short of beating the 1990’s for the magnitude of the gain in stocks. Then, we saw a 4x rise in the US market; even so, we are now in 2nd place against history, a little ahead of that other contender for bull market vigor, the powerful recovery from the great depression (1932-37) when the market gained 3.25x.

What has sustained the current long and strong bull market? Its supports are very complex. It is clear, though, that maintaining economic activity levels for a long period without a sustained dip or recession has been central to the longevity of the bull market. It is no accident, therefore, that the economic expansion phase of the global economy since 2009 is roughly coincident with the bull market itself. Using the length of the US economic expansion as the basis of comparison, we are about to break records. The paradox is that the current expansion, though long, has also been one of the weakest, evident in the feeble rates of economic growth seen since the global financial crisis. This holds for the US as much as it does elsewhere (the fiscal stimulus in 2017 boosted growth temporarily but this is now behind us).

That this relatively feeble economic expansion has still managed to break so many bull market records owes to two factors. First, there is the considerable strength in corporate profits, particularly in the technology sector. Profit strength has come mainly from rising margins, rather than growth in revenues, so it has been insulated from the lackluster economic growth impulse. Margins are now ebbing, though they remain at still very high levels relative to the past. Second, the benign behavior of inflation and interest rates have also been a big spur for equities and other risky assets. This has pushed valuations higher and kept them there, another driver of market strength.

Market has been losing support

As we have said before, the end of a bull market is not a sudden one-shot market event. It is a process, and large market falls come only at the end of it. This explains why we have referred to the past year or so as a ‘transition market’, conditions in which the bull market has lost its fire, but where conditions take a while to reach the final stage tipping point where the full market cycle is completed.

For a little over a year, we have been observing how the bull market has lost support compared to preceding years. This is largely because economic growth momentum and profits are under threat. A fear of rising interest rates was a cause of quite a lot of the volatility late last year, but after that brief scare, this threat has receded somewhat.

To cut to the chase, we see the supports for the current economic expansion crumbling. Though policy responses can shore things up for a time as they did late last year when the US Federal Reserve suddenly changed course, it is looking more likely that economic conditions will deteriorate rather than improve over the next couple of years. Interest rate cuts, probably coming this summer and/or early next, are not a clear-cut positive. They could be interpreted by the market as a reactive symptom of gathering economic weakness than as a driver of renewed market strength. It is also the case that profit margins are more vulnerable now given multiple threats stemming from regulation in the technology sector to cost pressures from protectionism. CEO/CFO surveys are now uniformly negative for some of these reasons.

How market and economic conditions interact

What is happening underneath it all is this. The inability of Europe/China to stimulate economies adequately to combat the slowdown since mid- 2018 and the diminished ability even for the US to stimulate given its interest rate and budget/public debt profile, is problematic for the global economy. Alongside, the unknown/unpredictable but hardly positive impact of deepening geopolitical risk and economic policy uncertainty (protectionism is only one example of the growing number of breaks from market-friendly policy), is bubbling away. Meanwhile, the late cycle environment of excesses in leverage-sensitive markets means that market and economic conditions are now more likely to interact in a way that makes a broader downturn more likely. We have already had a taste of this negative spiral in the way credit and equity market and economic conditions interacted with each other last December. Whether the economic downturn is in 12, 18 or even 24 months away is of less consequence than the fact that it is now looming large over our medium-term view horizon.

As a reminder, ends of economic cycles typically lead to worse market conditions than more normal market breaks. Markets do not need recessions or even strong reasons to fall, but it is a reality that recessions induce rather larger market falls and for longer periods than when other factors are pulling markets lower. Market falls in recessions through the last 9 recessions have averaged 40%. Some have been contained to about 20%, while several have been more than 50%, such as the 2008-9 market decline. The reason falls of this size happen is because of the high cyclicality of corporate profits and because of sharp falls in risk appetite which exacerbate and extend market falls.

Equity downgrade

We are taking our equity view further into a more cautious direction. We see the prospects for reasonable risk-adjusted returns in equities as having deteriorated further. We are signaling this by moving equities into the first notch of our negative grades in the medium-term view heat map and by moving to an underweight in the equivalent model portfolios we run.

This does not mean that the market cannot move higher. We very much believe we are still in a transition environment in which mini cycles of optimism and pessimism will continue. In fact, there is every chance that the current bout of central bank easing rhetoric (we have yet to see how much actual stimulus is/can be done!), some temporary easing of trade tensions and less concern about economic activity rates falling further could take the market through earlier highs.

However, our reckoning is that it will be difficult to make sustained market gains from here. Looking ahead on our usual medium-term view horizon, downside risks are also looming larger. This is not a ‘end is nigh’ call, more a sign that the transition environment progression is taking us nearer to the point where the market cycle will be completed.

Other than luck, however, the exact timing of when this happens is almost certain to elude us. This does not really matter very much. The idea is not to get that timing spot on, but to be reasonably well prepared for those very challenging markets.

All about diversification?

Being prepared means diversifying, but not all diversifiers are equal. One of the key difficulties is that some so-called diversifiers may not behave well in all cycles, just in some. Market conditions and relationships are inherently changeable, investor crowding reduces the marginal return available from a given strategy and sometimes we find that regulation or central bank intervention or influence crimps returns. As a result, we can easily find that things do not go to plan. We have seen several such diversification promises fail over the years during the financial crisis and beyond.

Past behavior has, therefore, to be interpreted in an appropriately questioning way. Special care needs to be taken with historic correlations. These can fluctuate very widely. For the newer asset classes like private credit, where growth has been mostly after the 2008 crisis, there has been no real test from adverse market conditions, as the odd episode of weak pricing has not lasted very long so that history becomes next to meaningless. Even where meaningful correlation data is available, more attention should arguably be paid to the relative rather than absolute correlation levels, since the latter becomes particularly unpredictable in stressed markets, with a tendency to move higher.

Asset class grid to help manage market conditions

Bonds, Cash and even Gold feature as more traditional stores of safe value, but we also explore alternative asset classes that lay claim to dampening volatility and helping alleviate capital loss – Real Estate, Infrastructure, Non-Directional Hedge Funds, Private Equity, and Private Credit, this is in Table 1.

We are leaving out intra-asset class tilts that will also lower portfolio risk – as noted above this will be typically important in a coping strategy – e.g. in the choice of higher quality credit or in a preference given to government bonds/duration within fixed income or defensive equity tilts like listed infrastructure or so-called lower risk/minimum volatility stocks which behave in a more bond-like way. We are also leaving out more direct tail-risk type strategies (which will be costly until/unless the market falls significantly) as well as direct protection strategies using options. This is not because these are undesirable, but because they are workable for a relatively small number of investors who are comfortable with complexity and their direct and governance costs.

All have competing positive and negative attributes and how to choose and mix, will depend on portfolio circumstances. But, to us a good diversifier currently is one that has a low correlation to equities and a reasonable return outlook. With that said, some appear better placed than others.

We believe that a combination of government bonds, non-directional hedge funds/alternative risk premium funds, direct real estate, direct infrastructure, cash, and perhaps gold, should feature in diversifying away from equities.

What should be done?

To us it is apparent that a lower risk asset mix seems sensible at this time since these market conditions are rewarding risk less well (and will in time give negative rewards for bearing risk).

What is being done within asset classes matters arguably as much too as higher or lower risk strategies will make a big difference to portfolio outcomes. Overall, more conservative, quality orientated, lower beta strategies less correlated to market risk are the way to go to cope with less friendly market conditions.

We need to be clearer on the specific actions proposed. De-risking raises cash. How should this be deployed if it is to be put to work? What are the investment areas today where de-risked cashraising should be directed? Which areas are likely to be most diversifying or capital protective?

The normal response for those showing more aversion to equity risk is to buy bonds. But there is a difficulty here. Bonds have already discounted the economic downturn given the implied interest rate profile – at present, we see bonds having over-estimated the extent to which interest rates can fall. As a result, any bond buying from equities is slower than it would be otherwise. Modest rises in yields from very depressed levels looks possible and need to be borne in mind when doing this most traditional form of portfolio de-risking. This is also why it may be better to look at a wider range of asset classes that we have highlighted as a destination for de-risked cash.

We believe that the following actions are worth considering:

• Portfolios on de-risking glide paths should stay inside their policy ranges. In general, they should not be overweight their target allocations to return-seeking assets, de-risking mostly from equities, not diversifiers.
• Credit exposures also offer a chance to de-risk at current valuations, particularly riskier exposures such as high yield and loans.
• If clients' strategic asset allocation targets are underweight Real Estate, and Infrastructure relative to our Model Portfolios, this is a good time to consider strategically increasing allocations.

^{Market information sourced from Factset
Diversification does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.}

^{1 Source: Aon Capital Market Assumptions Q2 2019}

^{2 Source: Aon Capital Market Assumptions Q2 2019}

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