Tcam's joint chief executive and CIO explains why there is no ordinary conclusion to the current cycle.
'It feels like we are entering the later stages of the current cycle – an odd thing to write when US interest rates have only recently topped 1%. However, mixed economic data, a relatively tight labour market and an increasing number of exogenous risks dictate that we are beginning to grow more cautious in our outlook. This has been no ordinary cycle and it may come to no ordinary conclusion.
Foreboding overtures aside, we believe the current bull market still has room to run, but opportunities will be more selective.
In a previous Investment Committee piece, we noted that we remain positive on Europe, financials in particular, both from a debt and equity perspective.
The sector is one of the few areas on which the market does not have a positive consensus and hence, the risk-reward dynamics look more attractive. In the UK, regardless of the political outlook, a number of good companies trade on undemanding valuations.
With the above in mind, we believe there are dangers in taking risk off the table too early, particularly as the final phase of a bull market is often accompanied by a sharp upwards move. Equally, as exogenous risks increase, so does the probability of episodes of volatility.
In the US, the Federal Reserve’s (Fed) assessment of the economy in its June statement was at odds with that of the market. The Fed lauded ‘solid’ job gains and sought to allay concerns regarding weaker inflation, noting that the measure is expected to stabilise in the medium term. However, the market remains unconvinced, on the grounds of tepid wage growth and evidence of sub-par job creation in the second quarter.
The Fed finds itself facing something of a dichotomy in the satisfaction of its dual objectives of full employment and price stability. Slack in the labour market has continued to diminish, but inflation remains stubbornly low. If the Fed’s medium-term confidence in personal consumption expenditure leads to further activity more quickly than the market anticipates, bonds in particular will struggle. Equities are also unlikely to be immune, in light of increased correlations in the current cycle.
Political risks are also pertinent. In the UK, Brexit looks set to be a longer-term storyline, although any threat to the negotiation of a transitional arrangement could prove to be the first flashpoint.
Equally, the threat of a Donald Trump impeachment, coupled with obstacles to progress in budget reform have seen ‘reflation’ called into question. The trade has been a key factor underpinning prices. Tensions with North Korea also continue to bubble below the surface, while any further slowdown in China has the potential to drive a flurry of panic selling.
Against this backdrop, our recent asset allocation meetings have focused on ways to protect capital in the event that volatility picks up, without the unnecessary sacrifice of upside if it does not. In the US, we have exposure to the S&P 500 with a covered call overlay and to this we are adding a protective put. This allows the holding to provide additional protection in sideways and falling markets.
Alternative assets also remain a key part of client portfolios for their ability to protect value in more difficult market conditions. We have recently added exposure to a long-volatility fund, which deploys rules-based trading strategies and is able to deliver protection at a lower cost than conventional options based approaches.
The size of the hedge will take account of the current level of volatility in the market. With our focus on protecting, as well as growing client wealth, it is important that portfolios are well placed to weather any forthcoming market uncertainty.'