Q: What indications did you observe that pointed to the recent market volatility storm?
A: In our adaptive risk allocation framework, one of the key first level characterizations we make on markets is whether interest rates are normal or too low. Instead of rising as most expected, interest rates moved lower and lower this summer. Eventually, they crossed a threshold where we have to ask whether something’s going wrong out there. And what typically drives interest rates lower is fear of a recession, deflation or financial crisis. We had no indication in the U.S. that such events were likely. But as we looked around the world, Europe in particular, those were exactly the issues that were coming to the fore. And so, Europe became, in a way, the center of global economic marginal gravity. It was this decline in rates, in combination with an increase in equity market volatility, that caused our market state classification to signal that a more preservation-oriented asset allocation was warranted as we entered the month of September (see chart below).
Source: Columbia Management based on an internal model. Historical occurrences are for the period 01/01/1970- 09/30/2014 and may not reflect future market conditions.
Q: So what do those lower rates mean in terms of opportunities for the rest of the year?
A: With interest rates being so low, investors may recalibrate their optimism, at least for a time. And that’s what we’re seeing across growth-sensitive assets like equities. I believe this is a bit of a false alarm; in Europe we have now gotten past the asset quality and banking sector review, which ought to open the door towards increased lending by the banks and potentially more action from the ECB. Europe has a chance of stabilizing, and I think investors might be too negative on that region. Similarly, I believe the combination of lower rates, a better European outlook and lower energy prices might be just the ticket to alleviate the mid-cycle pause in the U.S. stock market. So my central case for the rest of the year is that it turns positive and we work our way through the soft patch we hit last month. This view also aligns with our market state classification which currently suggests a more neutral risk-balanced portfolio allocation.
Q: Are investors being adequately compensated for taking risk?
A: In order to find any returns that are meaningful enough to help solve financial problems, you have to go out on the risk curve. And the overall pattern that we would expect is for that curve to flatten as investors take the bait, if you like, and bid up the price of riskier assets. And that’s certainly happened, by and large, over the past five years. But in 2014, it’s gone the other way. Compensation for low-risk assets like Treasury bonds has gotten much lower. And the compensation for taking equity risk has gotten a little better than it was at the beginning of the year. That’s because the return performance from equities has lagged the profit performance of the underlying companies.
Q: How does the strength of the U.S. dollar factor into your asset allocation strategy?
A: I still think we need to build our portfolio strategy around equity risk. However, we have to pay attention to the U.S. dollar because the stronger it gets, the weaker any return denominated in foreign currencies will be. We saw this very clearly in the third quarter, which we detail in our latest Investment Strategy Outlook. But it goes deeper than that. Emerging market assets, even in local currency terms, tend to underperform in the midst of a strong dollar; so do commodity returns. Overall, it argues for a more U.S.-centric risk approach. So I would say that currency risk can sneakily undermine efficiency, and it may make sense to emphasize the U.S. a little bit more in that context.
Q: Where do you see opportunity beyond the U.S.?
A: If we get an upside surprise for growth over the next 3-4 months, the place where I think sentiment has gotten most pessimistic is Europe. If the overall global context is one of relief, then Europe is probably the place where the rubber band is most stretched. So at least on a tactical basis, that could be a good place to emphasize.
Q: So given that sort of equity-intensive search for return, how can investors balance their portfolios?
A: One way is through the opportunistic use of the fixed income markets. At the moment, bonds remain a valid diversifier. But if rates get too low, and we’re flirting with that now, then we need to find other sources of stability and diversification. We like liquid alternatives and absolute return strategies as portfolio stabilizers and modern diversifiers. Another way is through a “participate, but protect” strategy which we highlighted at the beginning of the year. We believe that the same message is appropriate today. While our active asset allocation indicators remain favorable for the time being, we are constantly monitoring market conditions and are prepared to reallocate portfolios actively as conditions change.