Watching out for macro issues
Financial advisers hoping to protect their clients' assets from the shocks of volatility must have a better understanding of macro issues
Building a client’s investment portfolio usually revolves around the same few concepts – diversification, quality and staying as far away as possible from volatility.
But all of the hard work that goes into creating a well-thought-out strategy can go to waste if financial advisers are not also thinking about the impact of macroeconomics.
“When the Brexit vote came up in the UK last year, for instance, most people thought it wouldn’t get up,” says Roy Maslen, AllianceBernstein’s chief investment officer for Australian equities.
“But if you’re really focused on downside, you’re going to take preventative measures and be out of companies that are going get hurt in that environment.
“We think it’s important to spend a lot of time thinking about macro and also taking a ‘just in case’ scenario.”
However, it can be difficult to know exactly which issues to focus on, with the current environment bustling with controversial policies and overseas elections.
Mark Wills, managing director of State Street Global Advisors and head of the Investment Solutions Group, Asia Pacific, says it is important that advisers have a good idea of what their clients’ portfolios look like under stress.
“Analysing macroeconomic data is difficult, time consuming and extremely prone to investor bias,” he says.
“There are techniques to measure and management portfolio volatility which, for a retail client, can lead to permanent loss.”
According to a recent AB white paper, titled The Upside of Less Downside, one of the best ways to manage volatility is to create a diverse portfolio by investing in international stocks.
“The Australian equity market is relatively small, dominated by financials and a handful of large-cap stocks. In recent years, typically 10 to 15 stocks have accounted for around 50 per cent of the S&P/ASX 300 Index,” AB says.
“For these reasons, investors should consider moving away from the benchmark, and allocating a small part of their portfolios to carefully chosen international stocks that can fill the gaps in the Australian index.”
And the same goes for fixed-income investors.
“One way to reduce volatility [is] to diversify beyond the Australian bond market by investing globally, across all sectors (such as government, corporate and asset-backed bonds), without reference to bond market indices,” AB says.
But looking beyond Australia comes with its own risks, and advisers need to be sure they are not creating portfolios that solve one problem but creates another.
“Other methods of designing a low-volatility strategy could result in a portfolio having large amounts of risk from foreign exchange, US policy, European Union politics, and China’s economy,” AB said.
“It’s always possible to add a stock to a portfolio for the right reasons (stability, quality, and price), only to see it underperform because the related macro risks were poorly understood.
“Careful portfolio construction should aim to identify and reduce such risks.”
Trump’s tax agenda
Google the word ‘macroeconomics’, and a familiar face is sure to pop up.
US President Donald Trump continues have an impact on the global markets ever since the day of his unexpected election victory.
More recently though the world has had its eyes on Trump’s proposed tax reform which looks to cut the corporate tax rate from 20 per cent to 15 per cent.
Some analysts expect this reform to be a high stimulus for the US economy.
That is, however, if it ever gets passed. SSGA’s Mr Wills thinks not in its current form.
“Our view regarding the Trump agenda, like all presidents, his policy will be constrained by Congress,” he says.
“The Founding Fathers didn’t design the system to be a rubber stamp, and despite markets doing well under the White House, this republican leadership triumvirate will have to find an acceptable middle ground.”
However, 4D Infrastructure’s global equity strategist Greg Goodsell does believe Mr Trump’s fiscal stimulus measures will get through Congress, and add weight and momentum to the US economic recovery.
That’s because he expects Trump’s team will “double-up” efforts following the failure to repeal Obamacare.
“Trump’s recent legislative setback in not being able to repeal Obamacare can be looked at in one of two ways,” he says.
“The most common view is that the Obamacare experience will be symptomatic of what will happen with Mr Trump’s other big policies, such as tax cuts and infrastructure spend, in that he won’t be able to get the legislation through Congress.
“The alternative view is that, given the Obamacare fail, the Trump team will double-up efforts to succeed in legislating their other big signature policies.”
“We are in the latter camp.”
While some expect the US tax reform to have a positive impact on markets, there is another issue that has investors worried – the rising tension between the US, China and North Korea.
Kay Van-Petersen, Saxo Capital Markets global macro strategist, believes markets are heavily discounting the risks here.
“This is also because historically, there have always been issues and some form of minor conflict with North Korea. Yet people fail to understand nuclear capabilities are a game changer and this is the worst relations that North Korea has ever had with China in decades,” he says.
“The best investors plan in advance. If the US and China moved today to pacify North Korea, what would happen to the markets?
“What would you want to be short? What would you want to buy? What looks interesting 15, 20, 30 per cent lower from here?”
The good and bad sides of Europe
Across the pond, however, an election has taken place that is expected to see markets react positively and wants to drive the relationship with Germany “harder”.
SSGA’s Mr Wills says France’s new president Emmanuel Macron will likely try to advance more solutions for problems that the European Union is facing.
“The market is likely to react well to this type of initiative,” Mr Wills says.
That’s the prediction of Jun Bei Liu, Tribeca Investment Partners deputy portfolio manager.
“We expect European equities and the Euro to strengthen further,” she says.
“[Mr Macron’s] pro-European inclination and reformist agenda will drive a rebound and much needed confidence across the Eurozone.”
Still, others caution that the rally might be mitigated by expectations of rising interest rates and a renewed focus on the challenges Mr Macron will face.
In a reaction statement, Franklin Local Asset Management said: “We saw a partial rally in French equity markets after Macron’s first round success and we feel now investors’ attention may turn to his ability to govern after a difficult campaign.”
“In the longer term, we expect the Macron administration will likely position itself as a continuation of the previous government of Francois Hollande, yet with a more pro-investment and slightly more right-wing leaning.”
Meanwhile, Italy’s bad debt problem refuses to go away. SSGA’s Mr Wills says there is potential for Italy to exit the EU, which can pose a threat to investors.
“Italy is the world’s third biggest debtor nation…Italian banks are carrying $360 billion in nonperforming loans. Alitalia has filed for bankruptcy,” he says.
Mr Wills says the Five Star Movement, Italy’s Euro-sceptical political party, is leading the polls, with an election due in 2018.
“The threat is simple. If Italy has an election and the Five Star Movement wins, what then? What if they call a referendum to exit the Euro?” he says.
Around the globe, however, 4D’s Mr Goodsell believes “we are in the early stages of a synchronised global economic recovery.”
“If we are correct, and the recovery continues, it has scope to drive equity markets substantially higher, as well as significantly change the macro economic landscape,” he says.
But this comes with a warning, Mr Goodsell says.
“Accelerating global growth could be accompanied by increased inflationary pressures and rising interest rates – both of which would have significant consequences for an Australian society that has maybe grown a little complacent after a decade of low interest rates and low inflation.”
But there is something else worrying investors in Australia, and that is the slowing housing market and its effect on the broader economy, says Tribeca’s Ms Liu.
Leading indicators for the housing market have all turned negative over the past 12 months, she says, and there is already an impact on apartment prices.
“The increased focus by APRA and ASIC on speculative lending practices had seen a tightening in lending standards, increases in mortgage rates, in particular for investors, and is having an early impact on apartment prices,” Ms Liu says.
Over the five years, according to Ms Liu, Australia’s housing market had a “profound multiplier effect” through the economy, which acted as a cushion against the drag from the resources sector.
“Even though we have seen commodity prices strengthen more recently on the back of strength in China, this hasn’t translated into an overall lift in activity in the mining segments of the economy,” she says.
“We are wary of sectors directly and indirectly linked to the housing market, such as property developers and real estate businesses.”
SSGA’s Mr Wills, on the other hand, doesn’t expect a crash in the property cycle any time soon, given how low interest rates currently are.
But he does expect resource demand from China to be steady, with President XI Jinping focusing on a stable economy and financial markets.
Meanwhile, 4D’s Mr Goodsell would like to see better governance in Australia.
He says fiscal policy here has been badly managed over the past decade due to a combination of weak government and “populist/opportunist” politicians controlling the balance of power.
“Australia is well beyond being able to absorb surviving ongoing poor governance and it is essential that sensible, sustainable policy is put in place now,” he says.
“Failure to do so will see the coveted ‘AAA’ rating lost near-term, and over the medium-term would result in a continued gradual erosion of our standards of living and our ability to support the most needy in society.”
Tips for advisers
But beyond watching for macro risks, there are other ways advisers can offer their clients stability.
AB’s Mr Maslen has a few tips, with the first being investing in stocks with attractive stability, quality and price attributes.
“[The stocks] need to have some quality characteristics, and you’re willing to pay a little bit for these companies but not too much. Expensive companies become risk in their own right. So you want a reasonable price,” he says.
Secondly, Mr Maslen urges advisers to avoid ‘volatility traps’ – stocks that have shown low volatility but could change.
“There are three key reasons why this happens in Australian equities. The first is to do with cyclical risk. What you find is that a lot of companies that you own might typically be in strong, stable businesses but then something happens in their market and they become volatile,” he says.
“A great example has been supermarkets in Australia, with the entrants of foreign competitors. Obviously that has changed the dynamics and some of the share prices become a lot more volatile.”
Event risk is another way investors can fall into a volatility trap, Mr Maslen says.
“There are often events that are coming up but you don’t know the outcome. When events go against companies, things become a lot more volatile,” he says.
Perhaps the biggest tip for advisers is to remain focused “on the main game”, says 4D’s Mr Goodsell.
“Signs of global growth and inflation, both positive and negative, emerge every day, and it is important to continue to calibrate those against your expectations,” he says.
“It is easy to get carried away by issues that may well prove, over the long term, to be merely near-term market noise.”
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