Begin to rebalance into undervalued assets provided you have adequate liquidity to take advantage of additional opportunities that may develop. The 10%–20% decline in various equity markets from fourth quarter highs does not appear to be based on deterioration in fundamentals. Rather, markets seem to be reacting to fear about contagion from oil price declines and a slowdown in China, buffeted by underlying technical pressures. Many markets have moved beyond fundamentals, making rebalancing appropriate, with important caveats: (1) while not our central view for the near term, a global recession is possible; (2) fear and uncertainty themselves can turn sentiment negative, with negative consequences for the real economy; (3) asset valuations in some markets remain elevated or above levels at which turnarounds have historically materialized; and (4) what is cheap now has been for some time, so patience—and appropriate sizing—is a prerequisite for owning such assets.
We accept the consensus view that the global economy will slow but avoid recession; however, we cannot rule out the possibility that weakness will spread. Market declines tend to be more severe during recessions, but there are exceptions. US equities, for example, fell roughly 20% on a year-over-year basis outside of recessions on three occasions in the post-1950 era. The 1998 and 2011 corrections saw peak-to-trough declines just shy of 20% in an environment similar to today. Global growth remains low, credit spreads (even outside of energy and metals) have risen, US$ strength has pressured US growth and strained vulnerable offshore US$ borrowers, emerging markets are struggling, and commodity prices continue to fall. Meanwhile, growth in developed markets has been moderate, and is improving in Europe and Japan. Real consumer spending has been rising in the United States and the Eurozone, even as US consumers have increased savings rates. In the near term, a reduction in capex in the United States would pressure economic growth, but rising real wages, job growth, and lower energy prices should ultimately support consumption. As services account for 60% of the global economy, continued strength should offset manufacturing weakness.
Fear can certainly feed on itself and keep consumer and business savings rates elevated. Economic data could be poor over the coming months if capex is further slashed amid additional oil price declines and higher credit spreads, US inventories remain elevated, and weak equity market returns feed into negative sentiment surveys. At the same time, these fears could cause central banks to turn more dovish, sparking a market rally. We don’t put a lot of stock in this possibility as we recognize both the unprecedented nature of these interventions and the degree to which the arrows remaining in central banks’ quivers have limited potency.
If a global recession is avoided, developed markets equity valuations provide reasonable rebalancing points. As of January 20 lows, developed markets equities on the whole were at fair value,* with US equities about 20% above fair value, and other developed markets 17% below fair value in aggregate. US equities are now priced within our fair value range, but could fall further, especially if economic weakness takes hold, the US dollar remains strong, and/or energy sector earnings continue to deteriorate. Such an adjustment could take place even without an economic recession, as earnings already have contracted and profit margins have fallen. We would rebalance Eurozone and Japanese equities to overweight positions relative to US equities if currently underweight, but would be cautious in rebalancing US equity exposure.
Cyclical assets present an additional challenge. Much of what has become cheaper in recent days was already relatively cheap, so investors that have been leaning into these value opportunities are faced with the now-familiar question of whether to rebalance or maintain overweight positions. Natural resource–related assets have been beaten down the hardest over recent weeks. Energy master limited partnerships, natural resources equities, high-yield energy bonds, and commodity futures all appear to offer more upside than downside over the long term at today’s prices. However, commodity price uncertainty, particularly related to oil, is a significant hurdle. In emerging markets, equity valuations have rarely been cheaper, but in inflation-adjusted local currency terms prices and earnings have fallen only about 25%, well less than the roughly 50% adjustments experienced during the global financial crisis or late-1990s Asian financial crisis. Of course, there is no particular reason why such a severe decline must occur, but downside risks clearly remain. Investors would be wise to move slowly in emerging markets, taking an appropriately long time horizon (e.g., three to five years) and keeping overweights modest. Overall, we would be thoughtful about aggregate portfolio exposures to cyclical assets. While cheap, it may still take some time for these markets to recover. If a recession hits before the recovery takes place, better values will certainly be on offer. Investors should take a total portfolio perspective in considering how much to invest in beaten-down cyclical assets, and would be well served to maintain thoughtfully diversified portfolios consistent with their risk tolerance and return objectives.
We remain neutral on risky assets, and at the same time advocate keeping diversifying assets more defensive to maintain adequate liquidity to support future spending needs and capital calls, as well as to rebalance. Investors that have heeded this advice will have more leeway to take advantage of today’s opportunities as well as those still developing. Rebalancing, or any overweight positioning, should be done with insight into the look-through exposure of the portfolio and with consideration of risk tolerance. Such risk might be easier to absorb with adequate ballast in the portfolio in terms of high-quality sovereign bonds, cash, and defensively oriented hedge funds.
* We base our valuation assessments on normalized composite price-earnings multiples that combine several methodologies to smooth business cycle–related earnings volatility.
Celia Dallas is Cambridge Associates’ Chief Investment Strategist.