A Shift in Market Psychology: 6 Ways to Stay Ahead

Mona Mahajan | 27/03/2018

Summary

New volatility along with economic and market shifts may change the course of long-held investment strategies. Check out these six ways we think investors can stay ahead – while getting active.

2018 has already marked a clear shift for investors: after nearly two years of eerily complacent markets, robust economics and earnings momentum, and relatively subdued yields, risk markets have now begun to demonstrate a return to elevated, and perhaps more normal, levels of volatility. In the past, a buy-the-dip strategy – used by many investors – worked fairly well. But as we move further along in this cycle, we may continue to see a shift away from buy-the-dip, toward more selective, tactical and active management.

Peaking economic momentum and potentially rising rates, combined with recent uncertainties around global trade, tariffs, and turnover in Washington, D.C., are likely to keep volatility elevated this year. Below we discuss some of the potential economic drivers of this shift in market psychology, as well as ideas for investors to remain well-positioned through the cycle.

Has momentum peaked?

Over the past several quarters, US GDP and earnings revisions have demonstrated consistent upward momentum, helping drive positive sentiment in equity markets. More recently, we have started to see the upward revisions stagnate and even roll over, and it is increasingly difficult to see further upside surprise from current elevated levels.

A surprising surprise index?

US Economic Surprise Index, upwardly robust since June 2017, may be signaling a plateau.

A surprising surprise index?

Source: Bloomberg. As of March 16, 2018.

However, we do not foresee a downturn or recession in the US economy in the next six to 12 months. On the contrary, the US economy remains robust and will to some degree be supported by the new tax reform bill, as well as largely synchronized global growth, perhaps making 2018 a peak year for this cycle.

Is US real GDP all grown up?

Consensus forecasts for US real GDP show growth peaking in 2018 at 2.8%.

Is US real GDP all grown up?

Source: Bloomberg. As of March 2018.

Rising rates have sparked volatility

Investors are increasingly faced with the reality that the Federal Reserve is raising rates, and we may see a 10-year Treasury yield approach 3.0% by year-end. The market is slowly starting to price in the likelihood of the Fed raising rates at least three times in 2018. This also remains our base case, with a bias to the upside.

In addition to rate hikes, we are seeing a reduction in the Fed’s balance sheet, and thus US Treasury auctions that are above-average size and need to be absorbed into the marketplace. These forces, combined with gradually rising inflationary expectations, have created upward pressure on rates.

Rates may not be done rising

While gradually rising rates can be healthy for an economy, a sign of growth and a benefit to savers, if rates move too rapidly we could see a negative impact to the real economy.

Rates may not be done rising

Source: Bloomberg. As of March 2018.

The Fed will affect market liquidity

The Fed has already indicated that it will be removing liquidity from the financial system, both through rate hikes and tapering of its balance sheet. Importantly, the March 20-21 FOMC meeting will be the first one chaired by Jerome Powell, and investors will get valuable insight on how he may shape the Fed going forward. Among other data points, we will be looking for 1) any change in language around inflation expectations, and 2) the updated median glide path on the “dot plot,” or the projected rate-hiking path of the FOMC members. Keep in mind, the Fed recently reiterated that it expects the long-run federal funds rate to be 3.0%.

Faithful to a fundamental outlook

As we review our base-case forecast outlined at the beginning of the year, our fundamental outlook remains solid: we continue to see mid- single digit returns for 2018, well below the 20% returns we saw in 2017, but in-line for where we are in the cycle. We also believe that the Federal Reserve may likely raise rates three times this year, with an upside bias to this expectation.

And as we approach a turn in the cycle, rates and equities will likely remain volatile. However, there are ways to shore up a portfolio.

6 ways to keep ahead of the pack

Equities are a bright spot

We continue to favor equities, which can do well in a Fed cycle generally, despite volatility. The average annual S&P 500 return over the last four Fed cycles has been 9.2%.

Stick with big winners

Within equities, growth and large-cap stocks continue to outperform. And in a potentially inflationary environment, both can continue to do well. Our conviction lies in the long-term story of “winners from disruption,” particularly in technology and health care.

Valuing value

Over this cycle, value holdings will likely show signs of market leadership, remaining attractively valued versus historical levels. These companies may also benefit from tax reform and potential infrastructure spending. In particular, financials and certain industrial companies can do well in this environment.

Keeping up with high yield

Within fixed income, we continue to favor shorter-duration strategies, and as we do not see a rise in defaults over the near term, higher-yielding fixed-income securities remain attractive.

A view abroad

We favor exposure to international holdings, both equity and fixed income, as many countries are behind the US in their economic cycles and have more favorable valuations. We prefer Europe for value and dividend equities, Asia for growth and disruptors, and emerging markets broadly for fixed income and yield.

Given the alternative

As we get further along this cycle, we also believe investors should gradually increase allocation to alternative strategies, such as absolute return and private credit and equity, which are generally uncorrelated to equity markets over time.

As volatility persists in the markets, the case for active management has also re-emerged. We have seen many notable active strategies outperform during the correction period, which reinforces the value proposition of the active investor: in down markets, investors do not want to perform in-line with an index, they want to outperform.

Positioning with active over this next phase of the economic cycle can provide investors with a good source of alpha in their portfolios.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association and Investment Trust Association, Japan];and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.
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Mona Mahajan

Director, US Investment Strategist
Ms. Mahajan is the US investment strategist and a director with Allianz Global Investors, which she joined in 2017. As a member of the Global Economics and Strategy team, she is responsible for providing US retail and institutional clients with differentiated investment thought leadership. Ms. Mahajan is also a key spokesperson, communicating – both internally and externally – the firm’s high-conviction investment ideas and views from the Global Policy Council. Ms. Mahajan was previously a fixed-income portfolio manager, a structured-finance product specialist and a global market strategist at MetLife. Prior to this, she was an emerging-market strategist at Mirae Asset Global Investments; she also worked at hedge fund companies Para Advisors and Ziff Brothers Investments. Ms. Mahajan has a B.S. in economics from The Wharton School, The University of Pennsylvania; a B.A.Sc. in computer sciences from the University of Pennsylvania; and an M.B.A. from Harvard Business School.

Liquidity Shock: The Hidden Risk in Modern Markets

Steven Malin | 05/04/2018
Stormy sky

Summary

The risk of volatility spikes and liquidity shortages is rising, and it could get worse with new “quantitative tightening” policies from central banks. Politicians and regulators may eventually step in, but investors should take steps now to help guard against the possible loss of liquidity.

Key takeaways

  • Recent bouts of market turbulence have been brief but dramatic – a reminder to investors that liquidity shortages could make portfolios more vulnerable
  • New financial products, automated technologies and changing regulations are adding to volatility spikes and liquidity woes – and higher rates could make matters worse
  • To buffer against liquidity shocks, consider making portfolios more diversified, using liquid derivatives and building in enough time to recover from potential losses

Today’s markets contain hidden risks that increase vulnerability to volatility spikes and liquidity shortages.

The main sources of these risks are financial product innovations, automated and algorithmic trading practices, and regulatory adjustments put in place after the 2008 financial crisis as a means of strengthening markets. Also contributing to more “accident-prone” markets are diminished bank-bond inventories, the growth of high-frequency trading, and the proliferation of ETFs and rules-based trading strategies. In coming years, the gradual removal of monetary accommodation by central banks – which shrinks funding liquidity – threatens to exacerbate these risks.


Liquidity Shortages Exacerbated February’s VIX Spikes

VIX bid-ask spreads on 5 Feb 2018

Liquidity shortages exacerbated February’s spike in the VIX index

*The front month VIX future index
Source: Barclays Research, Bloomberg


The brief but dramatic episode of financial market turbulence at the start of 2018 serves as a reminder to investors to account for potential liquidity shortages in their risk-management practices. Protecting a portfolio against liquidity shocks requires a system to identify predictive signs of disruption, as well as having palliative action plans in place designed to meet these jolts. Meanwhile, Congress and regulators would be wise to support micro- and macro-prudential measures that can minimize risks related to the availability of liquidity, helping build investor confidence and, potentially, soften the impact of liquidity shocks.


Learning from the past: Lessons from the 2008 crisis

To be sure, financial markets became more liquid as the financial system regained strength following the 2008 crisis. Monetary authorities were forced to step in to assure that illiquidity in specific funding markets did not lead to sequential disruptions that would make the entire financial system inoperable. These actions proved highly effective.

Since the crisis, markets have also been made more mechanically efficient as a result of technological advances and product innovations. Worldwide, trades today are executed nearly instantaneously and at transaction costs that are only a fraction of what they were a few years ago. In particular, fixed-income markets have been transformed as barriers to entry have fallen and new liquidity providers have stepped forward. In turn, new electronic infrastructure also allows a more diverse set of investors to participate, increasing competition and improving market liquidity. Bid-ask spreads are now meaningfully tighter, complex documentation has been eliminated and risk has been reduced.

However, redesign of the financial landscape may have elevated liquidity risk, too. For example, reversal of the actions by central banks to assure market liquidity will entail many unknowns that could cause liquidity shortages and devolve into security prices cascading downward. As tighter monetary policy causes interest rates to rise, public and private sector debt servicing costs will climb and some marginal borrowers might be crowded out.

Furthermore, safeguards put in place by regulators to make the banking and financial systems more resilient, such as capital and leverage requirements, may make banks less willing to accept non-operating, short-term deposits, reluctant to underwrite stock issuance through rights offerings, and unwilling to buy bonds if a financial shock arises.

Ironically, algorithmic and automated trading platforms present challenges to market liquidity. Given the hyper-speed of automated transactions, apparently simple and innocent actions, can quickly initiate – without human intervention – a chain of compounding problems. These challenges can become even more daunting when transactions respond to rule-based approaches tied to low-volatility, momentum and dynamic-hedging strategies, particularly when investor confidence and market performance turn negative.


Liquidity from High-Frequency Traders Could Prove Ephemeral in Crisis

High-frequency trading as a percentage of overall US equity trading

Liquidity from high-frequency traders could prove ephemeral in crisis

Source: TABB Group, Allianz Global Investors as at 31 December 2016.


Even ETFs, whose enormous popularity among retail investors reflects little concern about potential illiquidity, could face a disorderly loss of value under crisis conditions. In the end, ETFs are only as liquid as their least-liquid holding. If bid-ask spreads widen as financial conditions deteriorate, fewer traders will enter the ETF market, leading to decreased liquidity and wider price swings. Redemption of fund units then leads to across-the-board selling of the underlying securities and contagion across asset classes which might send shock waves of distress to other markets.

In the event that a financial correction becomes intense, investors must be on the watch for rapidly falling security prices that could force asset holders to shrink their portfolios and hoard liquidity.


3 ways to guard against the loss of liquidity

  1. Maintain a broadly diversified portfolio to buffer against illiquidity in any individual market
  2. Use derivatives in portfolio construction, which tend to be more liquid than individual securities and investment funds
  3. Lengthen investment horizons to build in sufficient time to recover from losses incurred in disrupted markets, and avoid crowded trades to minimize the risk of entrapment if other market participants attempt to exit simultaneously.



Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association and Investment Trust Association, Japan];and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

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Steven Malin

Director, Senior Investment Strategist Global Economics & Strategy
Mr. Malin is a senior investment strategist and a director with Allianz Global Investors, which he joined in 2013. As a member of the Global Economics & Strategy team, he is responsible for making weekly global asset allocation and strategy recommendations; he also briefs clients internationally on the firm’s market outlook. Mr. Malin’s white paper series, Under the Macroscope, has a global following among business, financial, central bank and government leaders. He has 27 years of financial-markets, central-bank and investment-industry experience. Earlier in his career, Mr. Malin was a senior portfolio manager at AllianceBernstein, serving institutional, sub-advisory, Taft-Hartley and private clients throughout North America. He also worked at the Federal Reserve Bank of New York, reporting directly to the Bank’s presidents while serving as vice president in the communications group, corporate secretary and senior economist. Before that, Mr. Malin was the senior economist, founder and director of the regional economics center at The Conference Board; during that time he led a private economics consulting practice that included 25 Fortune 500 companies, trade associations and pension plans. He also served on the National Commission on Competitiveness, National Commission on US-Japan Economic Complementarity, Southern Growth Policies Board Economics Committee and the Corporate Advisory Board to the New York State Assembly Ways & Means Committee. Mr. Malin was an advisor to the Governors of Arkansas, Virginia and Montana on economic development and tourism. He also taught macroeconomics and risk-management courses at Barnard College-Columbia University and the City University of New York. He has a B.A. in economics from Queens College and a Ph.D. in economics from the Graduate Center of the City University of New York.
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