With the dramatic spike in market volatility over the past week, many investors are asking what comes next.
Markets entered 2018 with the wind at their back: double-digit equity returns, strong momentum, and expectations that the synchronized global growth and corporate earnings recovery we saw in 2017 should continue into 2018.
So damn the torpedoes, full speed ahead? Not quite, as recent volatility suggests some storm clouds could be gathering. Central banks globally are moving away from emergency levels of easing, and large fiscal stimulus in the U.S. in the late stages of the business cycle could have unintended consequences. And, of course, valuations matter.
We are not suggesting a sustained bear market in risk assets, as that would need either high odds of a recession or valuations that are not just rich, but in bubble territory. We see neither now or in the immediate future.
However, we argue that rich valuations combined with crowded positioning is not an environment to swing for the fences, but rather to seek to grind out returns by pursuing multiple country- and sector-specific macro or micro relative value opportunities. Singles and doubles, as baseball or cricket fans around the world would say, is the way to go, instead of looking to hit the ball out of the park. We believe that solid defense and the sum of hopefully many small victories is the path to achieving investment goals in this environment.
In our Asset Allocation Outlook 2018: “Singles and Doubles,” we aim to provide investors insights into better portfolio construction and diversification using the full tool kit available in today’s markets: which asset classes are likely to offer above-average returns, how to ensure both traditional and alternative risk factor diversification and how to hedge left tail risks (i.e., low-probability but potentially severe outcomes) judiciously.
As we discuss in the paper, we are slightly positive on equities from here, and are defensive on interest rate exposure generally, though we believe an allocation to government bonds is important in this late stage of the business cycle.
One of our high conviction views is to consider embracing commodities. The past several years have been challenging for commodities, but there are a number of reasons we believe they can play a role in investor portfolios in 2018 and beyond. Commodities historically have tended to do well in the later stages of a business cycle, and unlike equities, which tend to anticipate changes in growth and earnings, commodities are more rooted in the present and tend to outperform as capacity constraints are developing rather than in advance.
For more of our views on asset allocation, please see our Asset Allocation 2018: “Singles and Doubles.”
Mihir Worah is PIMCO’s CIO Asset Allocation and Real Return.