Risk-managed approach more essential than ever in 2017
With the surge in market optimism in the second half of 2016 and continuing into the first months of this year, some investors might be tempted to raise their risk budgets and increase their portfolio exposure to market beta. However, we urge investors to maintain a robust risk-managed investment approach to equity investing, to help navigate the potentially choppy waters ahead. We believe there could be a number of headwinds this year. This paper highlights some of these potential risks, in particular, political, valuation and inflation risk, as well as the state of the Chinese economy. We illustrate how Unigestion’s risk-managed approach has positioned investors’ portfolios to reduce the impact of these risks and safeguard against market drawdowns in 2017, including the pullback seen in March.
By Alexandre Marquis, Head of Investment Specialists and Maria Musiela, Investment Specialist, Equities
Last year the equity markets initially got off to a shaky start, with concerns focusing on Chinese growth and the weak oil price. However, global equities rebounded, spurred on by a recovery in commodity prices, a surprisingly resilient Chinese economy, relatively dovish central banks and improving growth outlooks.
Despite the multitude of obstacles along the way, in the form of US interest rate rises, the Brexit vote, the referendum in Italy and concerns over the country’s banks’ bad loans, uncertainty as to an OPEC deal, and finally the elections in the US, the markets maintained a positive, if bumpy, trajectory. The MSCI AC World Index was up 7.9% over the year in US dollar terms, the strongest annual performance since 2013. The strengthening US economy and favourable interest rate environment, along with the recovery in emerging markets, boosted equities, and, in particular, cyclical sectors. These sectors, which had fallen out of favour after the 2008 crisis, once again regained investors’ interest in the second half of the year, resulting in a sector rotation towards cyclicals and away from defensives (Figure 1).
This momentum was further compounded by an optimistic reaction to the promise of fiscal stimulus and deregulation by the Trump administration, with markets currently pricing in a positive growth impact.
Over the 2016 calendar year, cyclical stocks largely outperformed their defensive counterparts, as shown in Figure 2.
Given this euphoric picture, some investors may be tempted to increase the beta exposures in their portfolios. However, we believe that investors should always remain vigilant, even when others are throwing their chips on the table. We believe that despite the current optimism, 2017 holds a variety of uncertainties and potential stumbling blocks for markets. For us, now is not the time to become complacent but to adhere to a risk-managed approach when investing in equities.
We believe investors would be prudent to remember the following risks.
Political risks abound, with a busy schedule of European elections coming up over the next few months in the Netherlands, France and Germany, as well as the uncertainty around the implementation of a “hard Brexit” in the UK.
As illustrated in Figure 3, the level of economic policy uncertainty in Europe is rising, as measured by the Baker, Bloom and Davis index, which tracks the frequency of news article references to policy uncertainty. On the other hand, market pricing of political risk, as shown by credit default swap (CDS) spreads, a gauge of the market’s view of the risk of the issuer, has been subdued (Figure 4), only rising somewhat in France in light of the recent pre-election turmoil.
In the US, a lack of clarity as to the policies that the Trump administration will introduce, as well as the risks of increased protectionism and geopolitical friction, could also weigh on markets.
In the equity team at Unigestion, macroeconomic and political risks are part of our 360˚ risk-management process and are closely monitored, ensuring we assess potential emerging risks and their impact on various sectors and regions. For instance, our portfolios are currently underweight the UK, a position we are comfortable with in light of a potential hard Brexit and the uncertainty around the outcome of negotiations.
Valuations in some sectors and countries have undergone significant multiple expansions, driven more by market sentiment than fundamentals, with a lot of good news currently priced in. This puts some stocks at risk of mean reversion. The low interest-rate environment of recent years has led to increased investor demand for higher-yielding defensive stocks and caused significant expansion in the valuation of minimum-volatility strategies such as the MSCI AC Minimum Volatility Index, as illustrated in Figure 5.
We note that the underperformance of defensive stocks in the second half of 2016 has eased some of these pressures somewhat; nevertheless, valuations remain elevated. Since mid-2013, given the rising valuation risk, we started controlling for this risk within our portfolios. Our process seeks to safeguard our portfolios against excessively expensive names and the risk of mean reversion. We want good-quality stocks that have a favourable risk profile, but we ensure these stocks are reasonably priced, as illustrated in the chart.
The story in 2016 was one of reflation, and there is likely to be a continued rise in inflation through 2017 given stronger commodity prices and global wage growth putting pressure on input prices. Figure 6 shows the pick-up in CPI both in the US and Europe.
If inflation surprises on the upside, this will translate into higher interest rates and could have a significant impact on discount rates and stock valuations. This effect will be compounded in the case of expensive and more interest-rate-sensitive sectors. The extent of the impact will vary depending on the support from the growth story and stability of earnings.
Given this nascent interest-rate risk, we manage the duration risk of equity portfolios by limiting our exposure to stocks that have excessive interest-rate sensitivity.
Figure 7 illustrates the universe of stocks divided into deciles based on interest-rate sensitivity. We also chart the average risk level of stocks in each decile. We note that stocks with a lower risk profile tend to have higher interest-rate sensitivity (Figure 7).
Our approach ensures we control our exposure to the stocks in the three most interest-rate sensitive deciles, which are those deciles that experience the biggest price impact during periods of rate increases (Figure 8). The MSCI AC World Minimum Volatility Index has a significant allocation to these highly interest-rate sensitive stocks. This exposure makes the index much more vulnerable during periods of rate increases.
Chinese economy risk
The Chinese economy has been remarkably resilient during 2016; however, the issues that plagued markets at the start of the year have not dissipated. The high levels of debt, the overheated housing market and the dwindling effectiveness of stimulus measures are all still very much present. As shown below, China’s debt is now approximately 250% of its GDP (Figure 9), a level significantly higher than other emerging economies.
With the Politburo elections in the autumn of this year, we expect authorities to keep everything ticking along; however, the question is, what happens after these elections?
As a result of this uncertainty, we maintain a watchful eye on developments in China. We are currently underweight China in our risk-managed equity portfolios, and we also monitor our exposure to stocks that show higher sensitivity to the Chinese economy and the yuan.
Maintaining a vigilant risk stance
More than ever, we believe investors need a robust and active risk-managed strategy that will provide cushioning during market turmoil, because 2017 could entail some market volatility, with the potential for downside surprises.
However, it is important to remember that a low-risk strategy is not synonymous with a minimum-volatility approach, because passive defensive strategies are currently exposed to a variety of risks, such as valuation risk, interest-rate risk or crowding.
At Unigestion we use a comprehensive 360˚ risk-management process that focuses on a wide range of forward-looking risks, aiming to minimise our exposure to the unrewarded risks inherent in the market (Figure 10).
Our multi-faceted approach to risk management leads to portfolios of high-quality, lower-risk stocks that have the potential to generate long-term outperformance and provide improved downside protection during periods of market stress.
This document is addressed to professional investors, as described in the MiFID directive and has therefore not been adapted to retail clients. It constitutes neither investment advice nor an offer or solicitation to subscribe in the strategies or in the investment vehicles it refers to. Some of the investment strategies described or alluded to herein may be construed as high risk and not readily realisable investments, which may experience substantial and sudden losses including total loss of investment. These are not suitable for all types of investors. The views expressed in this document do not purport to be a complete description of the securities, markets and developments referred to in it. To the extent that this report contains statements about the future, such statements are forward-looking and subject to a number of risks and uncertainties, including, but not limited to, the impact of competitive products, market acceptance risks and other risks. Data and graphical information herein are for information only. No separate verification has been made as to the accuracy or completeness of these data which may have been derived from third party sources, such as fund managers, administrators, custodians and other third party sources. As a result, no representation or warranty, express or implied, is or will be made by Unigestion as regards the information contained herein and no responsibility or liability is or will be accepted. All information provided here is subject to change without notice. It should only be considered current as of the date of publication without regard to the date on which you may access the information.