No, assuming investors have heeded our advice to keep diversifying assets defensive, both to support future spending needs and capital calls and to rebalance and take advantage of opportunities that may arise. Of particular importance in times of market volatility associated with an uncertain shock is to make sure there is adequate liquidity—inside or outside of the investment portfolio—to meet near-term needs. Once liquidity needs are taken care of, investors can seek to capitalize on opportunities. In the very near term, we counsel patience, as it is unlikely that market volatility will subside quickly. This means remaining slightly underweight equities by waiting to rebalance into cheaper equity assets. In particular, investors should not rebalance allocations to UK and European equities until they have become more meaningfully undervalued and oversold, and should not rebalance Japanese equities until there is more clarity on the strength of the yen. Eventually, we anticipate opportunities will develop, as markets typically overshoot to the downside in the face of known uncertainty. If we are wrong, markets will recover and investors will be back where they started.
The United Kingdom’s vote to leave the European Union (EU) has raised a cloud of uncertainty that may last for several years. It is unclear when, and even if, the United Kingdom will begin the process of exiting the EU and what the economic, financial, and political implications will be. For now the consensus is that the near term, direct economic consequences will be a 1.0–2.0 percentage point drop in UK GDP growth, about half that impact on continental Europe, and a relatively minor 20–40 basis point drag on global growth over the next year, assuming there is no financial contagion.
While the direct economic risk of the UK referendum is likely to be largely limited to the United Kingdom and Europe, further downside risk should be considered given uncertainties about the political direction of Europe and the potential for the strengthening US dollar to once again crimp US growth, pressure commodities, and transmit stress to some emerging markets. Further, it remains to be seen how much ammunition central bankers have left to pump up the economy and support markets. At the same time, fiscal policy has been constrained, but somewhat ironically, the current situation may provide enough stress to encourage fiscal spending.
What context can we use to manage through such uncertainty? As the market and economic cycles have progressed, we have emphasized the importance of diversification into high-quality sovereign bonds, cash, and hedge funds with less equity and credit exposure. Late last year, we emphasized that investors should evaluate their circumstances to be sure they have sufficient liquidity to support future spending needs, fund unfunded capital calls, and rebalance.* For those that have not yet reviewed liquidity needs relative to sources of liquidity, it is not too late. While raising liquidity by selling risky assets in a falling market is not desirable, there are other options, such as securing a line of credit (depending on tax considerations) and reducing future obligations by becoming more selective in committing new capital to private investments if unfunded commitments are above manageable levels.
Once liquidity is adequately sourced, investors can focus on opportunistic investments. To better understand when to rebalance or even overweight assets that have sold off sharply, historical context on bear market drawdowns and valuations is helpful. Looking at significant equity market declines (those of at least 20%), the median decline has been about 30% based on the experience of UK and US equities for which we have the longest historical data. Of the 17 instances that UK and US equity markets experienced declines of at least 30%, only two produced negative returns for the five-year period after the 30% decline transpired and only six saw negative returns in the subsequent year. These periods of negative returns were marked by still-high starting valuations and/or very extraordinary circumstances (e.g., the Great Depression).
Some markets, even before the referendum, were already down more than 20% from 2015 highs, as concerns about economic growth have weighed on markets for the last year or so. As of Monday’s market close, EMU equities would still need to fall 8% and UK equities, 18% to get to roughly a 30% decline. Such declines would also bring these markets into pretty cheap territory. These cheap and oversold markets could benefit from continued currency weakness as well as energy price weakness, which could help boost earnings and returns. With currencies heading toward oversold levels, we would not hedge the currency exposure of these equity positions.
From a total portfolio perspective, we would be slightly more defensive than neutral today by waiting to rebalance into cheaper equity assets. We are also more cautious on Japanese equities despite their cheapness given the strength of the yen is certain to hurt the competitiveness of exporters that dominate the large-cap market. Focusing on smaller-cap issues is more appealing in this strong yen environment. The importance of maintaining high-quality diversification has been revealed several times since last August and should serve investors well in the coming weeks and months as more opportunities likely unfold.
* For a more thorough discussion on liquidity considerations, please see Mary Cove, “A Holistic Approach to Liquidity Management,” Cambridge Associates Research Report, 2016.
Celia Dallas is Cambridge Associates’ Chief Investment Strategist.