Managing Risks as Uncertainty Continues

August 19, 2019

As stewards of our clients’ portfolios, we are consistently balancing current market and economic information with our longer-term analysis of opportunities and risks. In making these assessments, we are inherently asking if there is anything new or different in what we are seeing that would trigger us to adjust our positioning. As our clients know, it is rare that any single development would prompt a portfolio shift, and the main reason for this is that we are already positioned for a range of scenario outcomes that regularly encompass much of what we see day to day.

At the same time, we acknowledge that this goes against a natural human desire to take action in the face of a changing environment. Current market volatility is a good example. As we write, we’ve recently seen some strong down-market days for stocks alongside an inverted yield curve for bonds—meaning long-term interest rates are now lower than short-term rates, which has historically been a fairly accurate indicator of a coming recession. We acknowledge that this type of volatility can be unnerving to investors—particularly as news outlets echo one another with alarming headlines about the global economy.

We are not alarmed by current events; instead, we have long anticipated a variety of global risk factors and positioned our clients’ portfolios accordingly.

Positioning for Global Risks

Over the coming years, we see a wide range of potential outcomes for global economies and markets. Some are positive, and some are negative. It is completely plausible that global economies and financial markets could experience positive developments that feed more positive developments, thus supporting continued growth and strong market returns, a least for a while longer.

However, the risk of a global recession and a bear market for stocks has risen. Economic growth in Europe and China may be decelerating, driven partly by the United Kingdom’s messy negotiations regarding their exit from the European Union and the trade war between the United States and China. The U.S. economy has grown for a record number of consecutive years, raising worries about how long this growth can continue. The prices of riskier assets such as U.S. stocks are high relative to their historical valuations, making their prices more vulnerable to disappointing news, such as recent events in U.S.-China trade relations.

Adjusting Our Portfolios

We position our client portfolios for both positive and negative events. Our goal is to capture returns from markets or asset classes where we see stronger potential while maintaining the diversification necessary to manage the downside from negative events. As we give more weight to the risk side of the equation, we will make incremental adjustments to our portfolios.

Some of the current changes being made are on the bond side of portfolios. Our bond allocations have been tilted toward higher-yielding bonds. Several of our selected bond managers have the flexibility to invest in bonds with lower credit ratings than investment-grade bonds, but where our managers’ analysis suggested these investments could generate higher returns with lower sensitivity to rising interest rates. Over our holding period, this positioning benefited our portfolios, with our bond allocations generally outperforming the Barclays U.S. Aggregate Bond Index, a broad index of the bond market.

Now that our research suggests that recession risks are rising, we have been selectively selling positions in these more opportunistically managed bond holdings—including what are known as “flexible bond” and “floating-rate loan” allocations. We are generally redeploying the proceeds to “safe haven” bonds, such as U.S. Treasuries, investment-grade bonds, or more conservative flexible bond strategies. Treasuries are considered more defensive investments because investors tend to favor them when the investment environment becomes riskier. In fact, we’ve seen that pattern lately as Treasury prices have risen and their yields have fallen alongside stock market volatility (though of course that can reverse). Their recent gains notwithstanding, we continue to like Treasuries for the downside protection they may offer if a downturn or recession occurs.

Looking Further Ahead

The silver lining of market volatility is that it can create opportunities for buying asset classes at attractive prices. As we find these investment opportunities, possibly in the more volatile asset classes like stocks, we will look at paring our holdings in bonds and alternative strategies to fund purchases where we see the potential for attractive returns.

As we are always scanning the macroeconomic, political, and market environment, we look for potential opportunities to grow the value of client portfolios or to protect them against downside risks. If you have further questions about how these opportunities may play out in your portfolio, or would like to discuss your individual situation, please feel free to contact your Litman Gregory Advisor.

 

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