Managing investments in volatile markets
Looking back at the volatility in the first half of the year, we are reminded that so many quarters have seen unusually high volatility lately, implying that higher volatility is quite usual, or at least becoming more normal. That’s often the case in periods of change, which we have been in since COVID shook up the world.
We have long been clear in our monthly updates that we believe the best way to manage investments in high volatility periods is to stay focused on the factors which drive market returns over the long term. Such an approach is an acknowledgment that it is challenging to assess the risks and rewards of adjusting allocations in periods of extreme volatility and it implies an assumption that no matter how bad things get, markets will eventually recover. While such an assumption is supported by the historical data (the S&P 500 Index continues to set new highs), we understand that it can sometimes take years to recover fully.
While tolerating volatility can be challenging, we believe that cutting or even eliminating exposure to markets that have suddenly been repriced in periods of high volatility can risk missing substantial upside in an eventual recovery, like the S&P 500 Index’s 9.4% single-day rise.
As such, we believe the best time to address the impact of high volatility is before the volatility arrives. In our portfolio construction process, we conduct numerous sensitivity analyses to gauge the effect of different paths for economic growth and inflation, interest rate changes, geopolitical shocks and more. These stress tests provide us with a framework to anticipate the impact of high volatility and thus adjust our risk exposures in advance of periods of extreme volatility.
But such a process also entails making some assumptions about longer-term structural trends. For example, our belief is that the U.S. economy has and will continue to adapt to the challenges it faces and that we are in a secular bull market, fueled by innovation, new technologies, productivity and investment. We also continue to believe that bonds offer compelling diversification benefits from equity exposure over the long term, and that current yields can offer attractive income.
Stay invested in large-cap stocks
We maintain our overweight allocation to stocks generally and favor large-cap companies in the technology and technology-related sectors as we believe these companies remain the key drivers of innovation, productivity and investment. For example, many mega-cap companies have made a wide range of investments in smaller private companies, acting almost like venture capital funds or incubators. While not every investment in a product or process will be a commercial success, we believe these companies have business models that can support long-term growth.
We continue to monitor the potential for their strength to spread to other sectors of the stock market but currently do not see the conditions to justify significant reallocations. If the economy achieves a soft landing, or if interest rate cuts are more widely expected, we could see some strength in the more cyclical sectors. Alternatively, if economic conditions rapidly deteriorate, prompting the U.S. Federal Reserve (Fed) to cut interest rates, small- and mid-cap stocks could benefit as these stocks typically carry significantly more debt on their balance sheets. Small-caps also tend to perform best coming out of a cyclical downturn as the economy reaccelerates. We have been slowly rotating a portion of our small-cap exposure into private equity funds that invest in smaller to mid-sized companies. This adds diversification away from public markets in addition to providing the opportunity to pick up exposure to an asset class that has long investment horizons and benefits from active ownership.
Turning to the rest of the world, European stocks outperformed U.S. stocks during the first half of the year by the largest margin on record2, in U.S. dollar terms. That is, given that the euro has rallied about 13% relative to the U.S. dollar over the first half of the year, converting a European stock investment made on January 1st back into U.S. dollars at the end of June would have provided a 13% return bonus on top of whatever gains the stock made in local currency terms.
And the outlook for Europe has changed as the region pivots to greater infrastructure and defense spending, while Germany’s economy could benefit from the recent removal of restrictions on the country’s debt limits. That said, it could take years for the benefits of this higher spending to trickle through the broader economy, and we remain of the view that Europe will underperform the U.S. in the long term given the region’s headwinds from challenging demographics, lower productivity and a high-regulation, high-tax business environment. Nevertheless, when the market rebounded after the April lows, we reduced our underweight to international equities on the expectation that U.S. dollar weakness could persist.
Bottom line:
- Remain moderately overweight equities given our positive, long-term outlook for the U.S. economy and U.S. companies
- Within equities, continue to favor large-cap and select mid-cap stocks over small-cap stocks
- We have rotated some small-cap exposure into private equity
- We have reduced our underweight position in international stocks and expect to retain this smaller underweight for the time being due to concerns that the U.S. dollar could weaken further
Favor shorter-term Treasuries and investment-grade credit
Bonds have provided and should continue to provide valuable diversification benefits in a balanced portfolio over longer periods of time, and while current yields can offer compelling income opportunities, we remain defensively positioned in fixed income as we believe interest rate volatility is likely to persist while longer-term risks are currently skewed to the downside.
Inflation remains a wildcard that is difficult to forecast given the numerous changes the economy is undergoing. While we expect it will remain contained, tariff hikes are often shocks to the economy, putting upward pressure on prices and downward pressure on economic growth. How much one effect overwhelms the other is very difficult to estimate, and we are concerned markets could be underestimating the magnitude of both.
Like investors, the Fed finds itself in a difficult spot, trying to balance its dual mandates of containing inflation and supporting employment. Each piece of data released will inform the Fed’s and our estimates. We expect the Fed to prioritize inflation containment over employment in the coming quarters, keeping rates higher for longer unless we see signs of significant weakness brewing in the labor market.
In the meantime, Treasury risk premiums may continue to rise. Often called a “term premium,” this is the extra yield required by the market to compensate for the risks of lending money and, intuitively, is typically smaller for short-term loans (such as Treasury bills) and larger for long-term loans (such as a 30-year Treasury bond). Just six months ago, the difference between the term premium for a five-year Treasury note and a 30-year Treasury bond was about 0.35%. Today, it is just below 1.0%, signaling increased concern about lending to the U.S. government for the long term.
Given the current concerns over the U.S. budget deficit, the tolerance of foreign buyers and the potential for further U.S. dollar weakness, we favor Treasury investments at the short end of the yield curve. While yields are lower in that segment, investment risk, interest-rate sensitivity and volatility are lower as well, and in the current environment, we think a more cautious approach is appropriate. Also, shorter-term bonds would benefit from Fed rate cuts, while concerns about debt levels could keep longer-term yields higher.
Within corporate bonds, we maintain a bias toward higher-quality borrowers in more defensive sectors, or those that are less sensitive to tariffs or general macroeconomic uncertainty, such as cable or telecom companies and utilities. In the consumer sectors, we have a similar view, remaining underweight sectors that are more sensitive to tariffs, such as the retail and automobile sectors.
One sector of the credit markets that looks more attractive to us is the municipal bond market. It has seen significant underperformance in recent quarters and has lagged other credit markets when stocks led a rebound from the April lows. Also, we have become more positive on agency mortgage-backed securities (MBS) as yields for these highly rated securities are compelling, and higher Treasury rates could slow homeowners paying off their mortgages, benefiting MBS.
Bottom line:
- Remain marginally underweight fixed income broadly as risks are skewed to further yield increases
- In the Treasury market, favor shorter-duration securities
- In corporate bonds, favor higher-quality companies less exposed to tariff uncertainty and macroeconomic weakness
- Consider diversifying exposure into municipal bonds and MBS
Volatility may be the new normal
Recent volatility may be the new normal. Given the numerous uncertainties that stock and bond markets face today, including an unclear trade policy, a particularly cloudy outlook for inflation and the effects of ongoing conflicts in Ukraine and the Middle East, it seems reasonable to expect sustained volatility to become the new normal.
As we believe investors should not make significant asset allocation decisions during periods of extreme volatility, we encourage a comprehensive review of portfolio allocations, helping to ensure that any particularly negative period does not compromise the ability to generate compound returns over the long term. Before making a change in your investment portfolio, you may wish to consult with a financial professional to determine how that may align with your long-term goals and objectives.