The adage “sell in May and go away”, referring to the historically weaker performance of stocks from May to October compared with the other half of the year, didn’t disappoint this time around, too. The summer, often a nightmare for any Chief Investment Officer trying to book a vacation, saw a sharp rise in volatility due to the triple whammy of:
The remarkable thing for that Chief Investment Officer who did manage to go on vacation, or anyone else taking some time off, is that little would have changed in markets upon returning in September. Global equities would be roughly unchanged, and US Treasury yields would have declined just a little. And yet, during that time, we witnessed the largest one-day decline in Japanese equities in history, and the VIX volatility index spiked to levels not seen since the pandemic.
While we got and are still getting some weak manufacturing and jobs data (the trigger for the volatility mentioned above and the subsequent bouts), we didn’t see a material deterioration in economic fundamentals. We also didn’t think that the economy was heading into recession in the near term. Instead, we thought (and still think) that the most likely scenario is a gentle deceleration to a more normal pace after very strong growth we’ve seen previously. We were also encouraged by Fed Chair Powell signalling in a recent speech that “the time has come” to cut interest rates.
Given this outlook, rather than (over)reacting to short-term price action, I and the Investment Committee decided to maintain our slight equity overweight. We still believe that US equities remain a compelling asset class, delivering solid returns at extended horizons. In the near term, though, valuations are on the demanding side. This is why we’re ‘neutral’ relative to our long-term, strategic asset allocation. More tactically, while representing a smaller share of our equity exposure, we have a small European equity overweight, as we find valuations relatively attractive.
The decisions from the Fed and European Central Bank later this month on whether to cut interest rates (we think they will) are likely to grab market attention. However, the US election is the crucial event for the remainder of the year and beyond. Investors tend to focus on whether the next US president is going to be Donald Trump or Kamala Harris. A critical debate, though, is whether the elections will deliver a divided or a single-party, unified government.
Divided governments tend to bring about extended legislative gridlocks, limiting the extent of policy action and, therefore, the impact on markets. Single-party, unified government raise the possibility of significant policy changes. So far, polls suggest that a divided government is the most likely scenario, although we’d take any such indication with a pinch of salt at this stage as things can obviously change. While polls put Harris slightly ahead of Trump, surveys of voter intentions in key swing states suggest that the race remains wide open.
A unified Trump government would seek to boost US growth via tax cuts and further deregulate the financial and energy sectors. The US dollar could strengthen. US equities could react positively to stronger economic growth, but the extra debt issuance that the fiscal plans would entail could negatively impact US Treasuries. Potential trade tensions and tariffs are also likely to affect non-US assets. This is especially a risk for emerging markets (EMs), which is why we currently don’t have active tactical positions in these regions.
A unified Harris government would boost spending, a moderate negative for US Treasuries, likely continue most of Joe Biden’s policies and be not much of a market mover relative to a Trump government. Clean energy could benefit, while oil & gas could be negatively impacted. However, corporate taxes would increase – a direct hit to corporate earnings. In terms of foreign policy, we’d expect a lesser risk of trade tensions with Europe and other NATO allies. When it comes to China, Harris will likely maintain a firm rhetoric, but there will be more predictability when it comes to tariffs.
While the August ‘flash crash’ is now behind us, there’s still a note of caution in investor behaviour for two reasons. First and foremost, we continued to have occasional bouts of volatility in early September. Investors have reacted negatively to the slightest data disappointment relative to market expectations, even when the numbers themselves, in an absolute sense, aren’t that bad. This could be a sign that a lot of good news, in the near term, is already reflected in asset prices, which means small downside surprises can weigh on valuations.
Secondly, equity volatility last week has risen again above average (though far from the peak seen a month earlier), utilities have led all sectors in August, and health care and consumer staples, which are key defensive sectors, have also done better than tech stocks. Gold, often seen as a hedge against uncertainty, continues to see solid demand. And government bonds, which saw rising prices during the volatility spike this summer, didn’t sell off again when risk appetite started to return. Importantly, we’re finally seeing again an inverse relationship between equity and government bond prices: when one falls, the other rises, providing a cushion in portfolios.
Over the course of the year, to navigate an increasingly complex environment, ranging from demanding market valuations to questions about the economic and earnings cycle and (geo)political risks, we’ve gradually increased portfolio diversification through strategic (long-term) and tactical (short-term) positions. The increased diversification should help mitigate these risks as volatility, which has picked up again, could increase further.
Our strategic investments in high-quality bonds, US Treasuries in particular, are fulfilling their traditional role as a hedge against downside growth risk. They cushioned the short-lived decline in equities over the summer. That said, we don’t think it’s worth being overly exposed, especially to long-dated US Treasuries over the next six months or so, given that the US fiscal outlook remains uncertain. Gold has also held its ground recently, and if geopolitical risks were to rise further, our commodities position would likely benefit, too.
The tactical position we initiated in short-dated European government bonds stands to benefit as central banks look set to continue cutting rates. And, looking at credit, we prefer European investment grade bonds to riskier high yield, as we think valuations aren’t attractive enough to take extra risk.
What’s more, the ‘insurance’ instrument we hold in portfolios (where permitted by client knowledge and experience, investment guidelines and regulations) partly protects against equity drawdowns across the US and Europe. Building well-diversified portfolios across regions and asset classes that can withstand a range of economic outcomes rather than just one single base-case scenario allows us to stay invested in high-quality assets with attractive long-term potential.
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