Having your cake, and eating it
But what if the end of days is not imminent? In that case, investors face a trickier call. With treasuries now priced for something close to economic catastrophe, the violence of the year-to-date moves would suggest that the time is approaching to rebalance their portfolios. But while a partial rebalancing out of treasuries is a relatively straightforward choice — if we are not facing a 2008 implosion, then it makes sense to position for stabilisation and a potential rebound — deciding exactly what to rebalance into is an altogether tougher proposition.
The obvious choice would be the broad US equity market. However, since the beginning of the year, the S&P 500 has gained considerable downside momentum. Nor, despite the recent sell-off, are US equities exactly cheap. Indeed, the S&P 500 remains among the most richly valued of all major market indexes. Moreover, with fears over negative interest rates hurting bank shares, the strong US dollar hammering manufacturing earnings, and the energy complex yet to work through the impact of cheaper oil, there are solid reasons to avoid a broad market exposure, even for investors who are inclined to play a near term reversion to the mean.
In that light, a more promising option may be not to rebalance into assets, like the broad US equity market, that have taken a beating over the last six weeks. Instead, investors might want to ask whether it is time to look again at markets that have been beaten down over a longer time span — since the US Federal Reserve signalled the end of its quantitative easing program in mid 2013 and halted asset purchases in late 2014.
The stand-out assets here are commodities, commodityproducers, and commodity-dependent emerging markets. Clearly investors should hesitate to include oil and oil companies among these rebalancing plays. Yes, the correlation of oil and equities over recent weeks implies that if risk assets stabilize and rebound, the oil price could outstrip equities on the upside. But the current correlation looks anomalous — and temporary. Cheap oil may be a near term negative for markets as energy company earnings suffer and fewer petrodollars get recycled into financial assets. But the resulting longer term wealth transfer from producers to consumers is a clear positive for global growth. What’s more, there are few signs that this transfer is going to reverse any time soon, at least not as long as Saudi Arabia has a clear geostrategic incentive to continue pumping as much oil as it can.
But away from oil, there are signs that low commodity prices may now be prompting the looked-for supply-side response as producers shut down marginal capacity and cancel capital investments. This dynamic has been clearly visible for some time in the iron ore market, where prices have collapsed -77% since February 2011, squeezing all but the most competitive producers. In recent months, however, the capacity closures have also spread to the non-ferrous metals sector, implying that the long slide in prices may be nearing a bottom. Supporting this view is the stabilisation since December of a range of commodity-linked currencies, including the rupiah, rand, real and Chilean peso. This stabilisation, coupled with the broader weakness of the US dollar over the last two weeks and the YTD outperformance of emerging market equities, at a time of prevailing risk-off sentiment, is highly unusual, and suggests that selling by “weak hands” may now be exhausted and possibly that EMs may be poised for a period of outperformance after years in which they have deeply underperformed.
Thus, for investors who are not convinced that a massive crisis looms around the corner, and who want to position for a stabilisation in asset markets and a tentative return to riskon investment sentiment, it may well be that rebalancing into the commodity complex is a more compelling riskreward proposition than rebalancing into broad US equities.
Such investors should retain sizable positions in longdated US treasuries and gold as a hedge against the worst case, selectively look to pick up oversold commodity-related assets as a mean reversion play, and hold long positions in US high yield, Canadian Reits, MLPs and Indonesian government bonds for their favourable carry. Of course, such a portfolio is a blatant attempt both to have one’s cake and to eat it.
But as London mayor Boris Johnson likes to say: “My policy on cake is pro-having it and pro-eating it.” In the current market environment, that’s a sensible approach.