In some ways, this is nothing new. Over the last few years the market has, as it normally does, climbed a wall of worry but the focus on capital preservation and the avoidance of volatility has been uncharacteristically pervasive in this cycle. The dominant market narrative has steadily shifted from one of secular stagnation to a sense that we are in a period of normalisation where a level of underlying economic growth can be sustained without central bank stimulus.
At this time of year, it is normal for macroeconomists and investment strategists to lay out their thoughts for the year ahead and think about how this may influence portfolio positioning. The experience of 2018 suggests that we may again be faced with an inconclusive set of data points that result in a number of mini-cycles during 2019. I remain of the view that the much talked about economic recession will fail to materialise and the real economy will perform much better over the coming year than consensus expectations, not only despite but possibly even because of factors such as tightening liquidity and higher government spending. Even if this scenario only has a modest probability of being correct, it has the ability to cause meaningful swings in expectations for key inputs such as inflation, the rates cycle and the outlook for earnings growth.
This means the risk of getting buffeted by a constantly changing market narrative is high and therefore trying to add value from traditional asset allocation approaches could prove problematic. This point is particularly interesting when one considers the increasing stock of assets which rely on generating at least a part of client outcomes in this way. Traditional asset allocation approaches are increasingly complicated by both the difficulty in conventional statistics to measure the modern economy and the poor capacity of the normal portfolio tilts to reflect the analysis. In all circumstances, it would seem that the analysis needs to be almost forensically accurate for an attributable benefit to be gained on a consistent basis after these effects are taken into consideration.
The clear temptation with such an uncertain backdrop is to retreat to the sidelines or to look to very conservative strategies. However, to do so may be to risk a high cost of omission. We know that with each market cycle the sources of inefficiency, and hence return, subtly (and sometimes not so subtly) evolve. Over the last cycle, a focus on fundamental value has had little efficacy in predicting future returns. Many of the investment strategies that have proven popular over the last cycle have involved buying securities based on how their price action correlates with others, rather than on how their price relates to the value of the firm. With the prospect of such powerful countervailing winds across markets, a focus on fundamental value may prove an effective true north in the coming cycle.
An interesting conclusion from looking at markets through this lens is that despite the overarching sense that we have been in an extended bull market (which technically we have) the lack of breadth and, importantly the volatility aversion that we have seen, has led to some key areas, especially within the equity market, looking cheap not only in relative but in absolute terms. To put the market returns in context, looking over the last five years, sectors like UK, EM and Europe have delivered either negative or low single digit returns in US dollars terms over five years cumulative. Looking at valuations at the level of broad indices is always complicated by the spread of ratings within them, but if we simply look at the available dividend yields on these indices, they are 4.8 per cent, 3.4 per cent and 3.8 per cent respectively.
Many of the areas that offer the greatest value at present, whether that be at the overall index level, more deeply within sectors or at the level of individual securities, do so because this is where uncertainty has been highest over recent years. When I think about the economic and market environment that sits in front of us where there will likely be short cycles of optimism and concern, there will be few points on which investors will be able to anchor their decisions: correlations will prove unstable, factors will prove meaningless, traditional market segmentation looks increasingly outdated and policy will prove not only unpredictable in its direction but more importantly in its impact. It is also fair to say that, from a behavioural perspective, the market has, over the last few years, made a direct correlation between volatility and risk and at the company level between ‘cheap’ and ‘failing’ hence the natural scepticism toward value as a predictor of future returns. These market blind spots are always interesting for investors to investigate.
For the coming cycle, investors need to look to fundamental value and crucially fundamental value at the security to guide them through these difficult to navigate markets. The strategy could prove far more rewarding that one might expect if one listens to the predominantly bearish sentiment out there.
Paras Anand is head of asset management, Asia Pacific at Fidelity International
