Preserve gains against market shakeouts

By Mohamed El-Erian. This article originally appeared on the Financial Times website, on July 30th, 2014

Despite signs of financial complacency, many investors are yet to formulate a comprehensive game plan to navigate the possibility of a market shakeout. The good news is this is both desirable and feasible, and the costs of doing so are quite low.

While they may differ on the specific magnitudes, the majority of investors would readily admit their portfolios have benefited from the sustained support provided to markets by central bankers. This has done more than bolster prices to levels beyond those strictly warranted by current fundamentals. It has also given the markets the confidence to repeatedly “look through” exogenous shocks, including quite a string of geopolitical tensions.

Investors also recognise that the US Federal Reserve is gradually reorienting and reducing the way in which it boosts asset prices – a message it is likely to reinforce this week by cutting its monthly purchases of securities by a further $10bn. And while investors may differ on the details of the hand-off, most agree the Fed will completely exit “quantitative easing” this year, relying more on forward policy guidance, all at a time when an increasing number of Fed officials are expressing concerns about aspects of investor complacency.

Despite this, few investors seem to have game plans to navigate a possible increase in market volatility – and understandably so. Through repeated experiences, they have been conditioned to have enormous faith in the steadfast support of the Fed.

Markets’ best friend

Most agree the Fed will remain the markets’ best friend until – and if – the US economy is able to stand confidently on its own feet, and to do so in a lasting and robust fashion that is consistent with high asset prices. This faith has been highly remunerated – by the Fed’s repeated willingness to venture into ever more experimental policies in support of the economy and markets, as well as by its willingness to calm disrupted markets (as it did after the “taper tantrum” of May to June last year).

Then there is the often tricky issue of timing. Judging from her reassuring words, Janet Yellen, Fed chairwoman, sees little reason to alter a gradualist policy approach. As a result, the vast majority of investors are confident they have a long and relatively stable road ahead of them before they need to correct their course.

However, high market valuations render investor portfolios more vulnerable to policy mistakes, market accidents and exogenous shocks. To help protect themselves, investors should consider enhancing the resilience of their portfolio management, in four ways.

First, when it comes to continuing to generate attractive risk-adjusted returns, sector- and security-specific portfolio differentiation (or what is known as “alpha” in the marketplace) is now even more important given the more limited scope for positive market-wide moves (“beta”). Investors need to be more event driven, including opportunities related to M&A (which will continue to grow to levels not seen since the global financial crisis) and disruptive technologies.

Second, rather than benefit from Fed actions, some foreign markets have struggled to navigate adverse spillover Fed effects. Within this group, the better-managed emerging economies (such as Mexico), as well as those likely to respond better after initial slippages (such as Brazil) remain attractive, warranting greater global diversification of equity portfolios with excessive home bias.

Resist temptation

Third, and more generally, investors need to resist the temptation of adding risk based only on relative valuations. They also need to ensure the risk they are taking is warranted by current market prices. If they fail to do so, they will end up exposed to what investors in high-yield bonds have discovered the hard way in recent weeks – namely, how an obsession with relative values leads to overextended absolute valuations and, subsequently, discomforting market corrections.

Finally, this is the time to build greater flexibility in asset allocations. This can take the form of larger cash buffers, cash equivalents and other short-dated liquid bonds, all of which facilitate portfolio repositioning to exploit what is likely to be a series of quite indiscriminate market shakeouts.

For more sophisticated investors, this can be achieved through option positions that monetise as market volatility picks up and valuations dip.

Investors are being given a chance to safeguard market gains and enhance the agility of their portfolios for the bumpy road ahead. The cost of doing so is quite low, especially when you consider the tricky handoffs that the Fed, the global economy and the markets will be facing over the next few quarters.

Mohamed El-Erian is chief economic adviser to Allianz, chair of President Barack Obama’s Global Development Council and author of “When Markets Collide”

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