One of the challenges of multi-asset investing is that the way in which asset classes behave varies depending on the market conditions at the time. In years gone by, portfolios consisted primarily of equities and bonds in the belief that when one fell the other would rise. Such a mix worked well on many occasions, and negative correlation can often be seen when a stock market sell-off is caused by fears of an approaching recession. In such circumstances, investors tend to run for the relative safety of Fixed Interest, with increased demand and the expectation of lower interest rates to help stimulate the economy both pushing up bond prices, helping to offset losses in equities. However, if the stock market sell-off is caused by something else, for example fears over interest rates rising too high, bonds and equities will often fall together, providing no protection to investors. This potential correlation led investors to broaden their portfolios, and the growth in multi-asset investing speaks to how well that has worked. However, a wider range of asset classes does not diminish the importance of knowing how each will behave in various market conditions.
With the current economic expansion now the longest ever by some measurements, it is not surprising that one of the behaviours most examined by investors currently is how well an investment will hold up in a sell-off. Whilst we have touched already on how asset class correlations can vary, the same is true of different parts of the same asset class, and we will use equities to illustrate the point. Historically, value stocks, being companies whose share price has fallen as they are out of favour, have often held up better in a sell-off, possibly because they have less far to fall when the ‘crash’ comes as their share prices have fallen already relative to the market. However, since the Global Financial Crisis of 2008/9, growth stocks, and ‘quality growth’ stocks in particular, have held up better in market corrections, as investors have preferred the perceived security of well-established cash-generative companies that are growing their market share. This has led to such companies trading on rich valuations, so much so that there is evidence that the trend may be reversing. This difference was seen in Q4 2018, when highly valued ‘growth’ companies were sold off aggressively whilst value stocks suffer less. However, in the rapid market recovery that followed, the share prices of many growth stocks have returned to something like their previous levels, so it remains to be seen if value will be a more defensive part of the market going forward.
A recent piece of research by Morgan Stanley titled “Are You Sure That’s ‘Low Beta’?” noted the same change and suggested it was a longer-term trend that was not limited to just Q4 2018. They noted that the US market was showing similar signs of ‘high beta downside capture’ i.e. falling more than average in sell-offs. This is noteworthy because the US market has been seen historically as a safe haven, underpinned by the world’s largest economy that has strong domestic drivers, meaning that it is less affected by a global slowdown than economies with a large export component, like Japan and Europe. Of course, these two apparently different data sets may be showing the same thing. Technology is the largest sector within the US stock market at over 20% by market cap, and many of these technology companies deserve the ‘expensive growth’ tag. Therefore, the fact that the US market is no longer looking as defensive may not be a great surprise. However, with evidence that the protection provided to overseas investors through currency may no longer be available (the US dollar used to rise when markets fell but recently has fallen in concert), the US may need to be viewed differently going forward.
So what does this tell us, if anything at all? Ultimately, if a portfolio is properly diversified, investors should not be overly exposed to assets behaving differently from the way that they have in the past. However, for returns to be maximised, it is important to monitor markets as they evolve and position accordingly. That is not to say that investors should be underweight US equities and growth stocks. If the US/China trade war gets completely out of hand, investing in an economy like the US that has a large domestic component may well prove to be a good decision (we hold India for the same reason). Furthermore, our core case is that this cycle can continue and, in such a low growth/low interest rate environment, growth stocks tend to do especially well. However, there is no doubt that, from such elevated valuations, quality growth stocks have the potential to fall more than the average. Any increased risks in these areas need to be factored in and, for that to happen, they need to be acknowledged. Therefore, we continue to weigh up a number of contradictory factors, tilting the portfolio where we see opportunity but being careful not to expose investors to binary event outcomes.