Diver­si­fy­ing and stay­ing the course in the eye of the storm

Gulf News - - Your Money -

By the time you read this note, we will know whether or not Hur­ri­cane Irma made land­fall in Florida. The state de­clared an emer­gency al­most a week ago. Since then the storm has crashed through the Caribbean leav­ing dev­as­ta­tion in its wake. The US, for its part, has been brac­ing for im­pact even as it deals with the flood dam­age of Hur­ri­cane Har­vey.

Our thoughts are with the vic­tims of th­ese storms, and we wish the best for those who re­main in Irma’s path.

Fi­nan­cial storms sup­pressed

If Irma has hit Florida as at least a Cat­e­gory 4 storm, it will have been the first since Hur­ri­cane Wilma 12 years ago. Com­ing just a week or so after Har­vey, this would be the first time on record that two storms of this mag­ni­tude have struck in the US in a sin­gle sea­son. But de­spite ap­pear­ances, when it comes to the weather, longer pe­ri­ods of calm do not lead to a higher like­li­hood of more ter­ri­ble storms in the fu­ture.

Fi­nan­cial mar­kets can be dif­fer­ent. An ex­tended pe­riod of lower volatil­ity and higher as­set val­ues can lead to greater risk-tak­ing and in­creased lever­age in pur­suit of re­turns, mak­ing the po­ten­tial storm much big­ger should in­vestors try to re­treat.

More­over, while hu­mans can do lit­tle to sup­press trop­i­cal storms, we can and do act to sup­press fi­nan­cial storms. The past decade of ex­tra­or­di­nary cen­tral bank in­ter­ven­tions is a pos­si­ble po­tent ex­am­ple of a fi­nan­cial storm de­ferred, and politi­cians are masters at cob­bling to­gether quick fixes for long-term, struc­tural chal­lenges.

Kick­ing the can

Iron­i­cally, it was Hur­ri­cane Har­vey that pro­vided Pres­i­dent Don­ald Trump with the cover for a quick fix for the im­pend­ing US debt ceil­ing and bud­get rec­on­cil­i­a­tion tem­pests. He struck a deal with the Democrats to post­pone th­ese dif­fi­cult de­ci­sions un­til mid-De­cem­ber to free up dis­as­ter-re­lief funds in the mo­ment.

Repub­li­cans in Congress who wanted to use the dead­line to press for fis­cal and struc­tural re­forms were not happy.

Trea­sury bills ma­tur­ing in Oc­to­ber, whose yields had climbed to Septem­ber 2008 lev­els, ral­lied hard, and those ma­tur­ing in De­cem­ber sold off. Amid all of this, how­ever, long-dated bonds barely moved.

After all, US and global eco­nomic fun­da­men­tals re­main slow but steady — the “Goldilocks” sce­nario — and it is true that all of our mon­e­tary pol­icy and po­lit­i­cal can-kick­ing can help to ex­tend this ex­pan­sion­ist stage of the busi­ness cy­cle.

Stay­ing weath­er­proof

But in­vestors should not mis­take the cur­rent mar­ket calm for gen­uine fair weather. It could be the eye of a storm.

Things can stay calm if we keep mov­ing with the hur­ri­cane swirling around us, but there are many things we might stum­ble over: a tac­ti­cal er­ror over Korea, or a de­ci­sion by the Fed­eral Re­serve as it at­tempts to nor­malise mon­e­tary pol­icy while re­cy­cling many of its se­nior per­son­nel, or from a US pres­i­dent pil­ing more and more onto the leg­isla­tive agenda of a di­vided Congress, alien­at­ing his own party and fail­ing to push the debt ceil­ing pinch point be­yond the next ses­sion.

None of th­ese ex­oge­nous risks have blown mar­kets off course yet, and, as with weather sys­tems, buy­ing time can al­low their pent-up en­ergy to dis­si­pate. In the fi­nan­cial sys­tem, how­ever, time can equally al­low a Cat­e­gory 3 storm to ramp up to a Cat­e­gory 5.

As such, in­vestors who recog­nise that we may be in the eye of a storm should con­sider stay­ing their course when they hear the winds around them: Re­main di­ver­si­fied.

Main­tain ex­po­sure to broad mar­kets. But also, cru­cially, con­sider other sources of re­turn, such as un­cor­re­lated hedged strate­gies, al­ter­na­tive risk pre­mia or rel­a­tive value op­por­tu­ni­ties that may be less likely to leave port­fo­lios over­ex­posed to a sud­den change in the weather — fair wind or foul.

The writer is Chief In­vest­ment Of­fi­cer — Multi-As­set Class of Neu­berger Ber­man.

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