INVESTED: In Markets, in the Future, and in Society.

In a recent issue of Invested, we explored why the “Fed put” may be kaput, and what this means for investors. With inflation at levels not seen since the 1980s, the Fed is less likely to provide the liquidity needed to support financial markets, spelling trouble for investors that have been conditioned to “buy the dip” when stocks hit a rough patch. I expanded on this line of thinking in a recent commentary, opining that even though both stocks and bonds have had a horrible first six months of 2022, the potential for unintended risks continues to loom in equity markets. This doesn’t necessarily mean that there is no risk in bond markets and the bloodletting is over, just that equity markets may be too sanguine about the underlying macroeconomic conditions and the functioning of the Fed’s response mechanism. My thesis is that while equity valuations have certainly cheapened relative to the start of the year, most of this cheapening has occurred because interest rates are rising, which has the effect of lowering valuations due to a higher discount rate. What hasn’t been priced into equity markets is any sort of slow down in earnings due to financial conditions tightening as the Fed looks to rein in inflation. Forward-looking estimates of earnings per share for global equities are expected to increase by 12 percent over the next year. While this may be a reason for some equity investors to be optimistic, the potential for a Fed mistake and an overly aggressive tightening path has yet to be priced into equity markets.
 
BlackRock came out with a note last week warning dip buyers about trying to catch a falling knife, highlighting not only the risk of the Fed tightening financial conditions too aggressively, but also the risk to corporate profit margins as higher energy prices and labour expenses take their toll. While there are reasons to be optimistic, the Fed will be able to pull off a soft landing and get inflation under control without pushing the economy into a recession, this Wall Street Journal article highlights that when the S&P 500 has declined by more than 15 percent, stocks only manage to find a bottom when the Fed shifts toward loosening monetary policy. So even though stocks are now officially in a bear market, stubborn inflation may force the Fed to stay on an aggressive tightening path, and any loosening of financial conditions may be further away than one expects. As such, equity investors may not be out of the woods just yet. 
 
At Viewpoint, we’re obsessed with quantifying and understanding the concept of risk, which goes beyond making discretionary forecasts and opining on when “the coast is clear”.  The truth is, the coast is never clear for financial market participants, and we believe that what investors should be focused on is how to create the most efficient investment portfolios when controlling for risk. In the current market environment where financial assets are being predominately driven by inflation and associated monetary policy responses, investors may need to rethink their risk management strategies.
 
The first lines of defense for any investment portfolio should be to reduce concentration risk so that portfolio risk is not dominated by any one risk factor. At Viewpoint, we believe that utilizing a risk-parity framework where each asset class contributes the same amount of risk to the overall portfolio results in a more efficient, risk-aware portfolio. The risk balanced approach creates a diversification premium, which can then be harvested by scaling volatility to match that of equity markets. The result is a portfolio that has a similar risk profile as equity markets, but one that is much more diversified and robust to various market cycles. Additionally, by scaling the portfolio to target a certain risk level, in times of financial stress when volatilities and correlations rise, the portfolio reduces gross exposure to dampen risk. For additional granularity on the analytics behind a risk-parity construction methodology, we have written a two-part blog series on the benefits of utilizing this approach when constructing portfolios. That series can be found here and here. 
 
We can further expand on the concept of risk management by looking at active overlays that are designed to preserve capital and guard against the unintended interruption of compounding. Earlier this year we released a blog post on how the practical application of trend in an investment portfolio can provide a robust risk management framework to reduce the probability of volatility induced sub-optimal decision making. 
 
When markets are going haywire, you can give your amygdala a break and take comfort knowing that there are risk management strategies in place to help guard against the heightened volatility.