Going neutral on equities, trimming exposure to growth stocks and adding to absolute return funds are some of the strategies that one JP Morgan market strategist thinks can help investors prepare for the next downturn.
In its quarterly forecast, JP Morgan Asset Management revealed that it retains “a degree of caution” about the near-term outlook for global equity markets.
While the economic and market cycle will receive a degree of support from more accommodative monetary policy, the firm believes some investors place too much confidence in the ability of central banks to fix all the world’s economic ailments.
It noted that, in reality, central banks are working against significant geopolitical headwinds deterring companies from investing and putting a cap on how far markets and economic growth can run.
According to the latest International Monetary Fund figures, world economic growth is expected to slow from 3.6 per cent in 2018 to 3.3 per cent in 2019.
Real GDP growth (annual % change)
Source: IMF World Economic Outlook, April 2019
The forecasts for 2019 and 2020 have just been marked down by 0.4 percentage point and 0.1 percentage point respectively. “Risks are tilted to the downside,” the IMF said in this week’s World Economic Outlook.
However, JP Morgan Asset Management global market strategist Michael Bell said it is possible to build a portfolio that can withstand the hard blows of a potential downturn in the economy and equity market.
“Given yields are already so low in core government bonds and high-quality credit, investors may want to adopt a balanced portfolio of equities, fixed income and alternatives while thinking about shifts that could improve the resilience of an overall portfolio,” he said.
Bell admits there’s nothing to suggest the US recovery — the second longest on record — will end in the near future. But “expansions do not last forever,” he noted. He has put forward seven portfolio-boosting strategies for investors who are concerned about an equity market downturn.
1. Move towards neutral in equity, but avoid underweights
In the period preceding a US recession, equities can still yield strong positive returns so Bell warned again going underweight equities too early.
“For example, an investor who called the dotcom bubble too early would have missed out on a return of 39 per cent in the final two years, or 19 per cent in the final year, of the S&P 500 rally,” he said.
Equities begin to struggle only when the market start to price in a recession but markets have peaked anywhere between zero and 12 months prior to the start of the recession.
“Given the difficulty of precisely timing market peaks and troughs, investors may want to consider moving closer to neutral in equities in the late stage of the economic cycle,” the strategist added.
S&P 500 returns around market peaks
Source: Standard and Poor’s, Thomson Reuters Datastream, J.P. Morgan Asset Management
2. Remain regionally diversified in equities
During a recession, prudent investors maintain a regionally diversified portfolio. “A shift in regional allocation rarely helps cushion performance in a market correction,” Bell pointed out.
While investors could be tempted to move away from US equities if they expect a recession, stock markets in all other regions tend to fall during a downturn – sometimes more than US equities.
“When you add in the fact that the dollar appreciated during the last two recessions, it’s far from clear that concerns about a US recession should lead investors to shift from US equities into other equity markets,” Bell continued. “Investors are normally better off maintaining a regionally diversified portfolio.”
3. Rotate away from overweights in mid- and small-cap equities
For his third portfolio defence strategy, Bell said: “Small-caps tend to underperform the market during recessions, particularly in the UK.”
Indeed, between May 2007 and December 2008, UK mid-cap stocks underperformed the FTSE 100 by 18 per cent and have since outperformed by 200 per cent. The average UK equity fund has over 40 per cent in mid- and small-cap equities, which is a 20 per cent overweight to the FTSE All Share.
4. Reconsider overweights in growth stocks
Growth stocks have led the way for much of the post-financial crisis bull run, but the JP Morgan strategist argued that they have often underperformed value stocks during S&P 500 bear markets.
“The obvious exception was the global financial crisis, when value underperformed, although this was because of the high weighting of financials in the value index during a crisis in the US financial system,” Bell noted.
However, he argued that the next recession is likely to be a “normal” recession and less likely to turn into a financial crisis, suggesting value might once again outperform growth.
He also pointed out that quality – or companies with high profitability and earnings quality and low financial risk, with a focus on strong cashflow generation – is the only investment style to outperform the index in every recent downturn.
5. Consider fixed income strategies that can shift across regions, duration and risk
Sometimes, credit starts to underperform before equities peak. Flexible strategies designed to reduce credit risk and increase duration as the recession risk rises can help protect a portfolio.
Furthermore, in a low interest rate environment, investors should prefer funds with the ability to shift to government bond in markets where central banks can cut rates and avoid markets where government debt could be a major issue during a downturn.
Treasuries can help protect portfolios during equity downturns, while credit underperforms
Source: Bloomberg, BLS, JP Morgan Asset Management
6. Cash may provide ballast
In an environment of negative rates, which has been case in recent years, holding cash is not a good strategy.
However, in the context of a tactical allocation, cash and liquidity instruments can provide much-needed stability to a portfolio. They can also provide an extra peace of mind needed for some allocation to risk elsewhere in the portfolio.
“Obviously, investors would also need to consider currency risk if investing outside of their home currency,” Bell cautioned.
7. Consider strategies with low correlation to risk assets
The practice of lowering correlation to risk assets is never more important than during a downturn so Bell recommended investors look for strategies that aim to do just this.
“Some examples include macro funds and equity long/short funds, particularly those with the ability to take their net equity exposure to zero,” Bell said.
He warned, however, that some equity long/short funds have a structural positive – albeit lower – beta equity to markets, which means they will capture some of the downside.