This post was written with contributions from Anqi Dong, CFA, CAIA. Anqi is a Senior Research Strategist on the SPDR® Americas Research Team.
Reignited trade tensions, a potential no-deal Brexit, and signs of an economic slowdown are making markets jittery.
The second half of 2019 isn't likely to calm down. Bouts of volatility and big market swings are still expected as investors try to make sense of an increasingly uncertain geopolitical landscape, while central banks may step in to try to calm markets with their accommodative policies. Rather than moving to the sidelines, investors should focus on areas that are less likely to be impacted by the trade conflicts, adding more resilience to the portfolio in the form of downside protection.
Strategies to lower overall portfolio risk
Several tools are available to investors to mitigate risk throughout the portfolio.
1. Equity strategies that provide upside participation but mitigate drawdowns
As shown in the chart below, low volatility and quality factors have historically performed well during economic slowdowns – defined by decelerating year-over-year growth of the Conference Board Leading Economic Indicator (LEI) Index. Since October last year, the LEI index growth has been on a downward trend, falling to 1.6% in June. Quality has led factor performance this year, outperforming the broad market by 4.7%. Low volatility ranks at the top on a trailing 12-month basis, when the market experienced multiple drawdowns of more than 5%. As economic uncertainty persists, the two factors are likely to continue showing resilience. Targeting strategies that blend these factors together, resulting in a low volatility strategy that also has upside potential, may be ideal.
Source: Bloomberg Finance, L.P., as of 5/7/2019. Quality , Min. Vol., Value and Size are represented by the MSCI USA Quality, MSCI USA Minimum Volatility, Russell 1000 Value, and Russell 2000 Indices. The market return is represented by the MSCI USA Index. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
2. Let bonds be bonds
Continuing the themes discussed in our mid-year outlook, bond exposures can potentially offset equity risk within the portfolio. However, not all bonds are the same. Below investment grade credit has become highly correlated to equities. The curve has flattened and long-term rates have fallen so dramatically that the yield per unit of duration is sub-optimal to more intermediate parts of the curve. Therefore, given the late-cycle dynamics in play, active and intermediate-duration bond strategies can offer the potential for increased income and return without uncompensated duration or equity-like risks.
3. Strike a defensive tone
Finally, gold typically performs well when volatility spikes. Gold has appreciated +6.7% on average during the last nine market downturns, while the S&P 500 has pulled back an average of -13.3%1. That same trend has continued so far this year, as gold prices broke through the psychological 1,500/oz. barrier on the back of persistent geopolitical tensions and real interest rates turning negative. Gold has historically had a negative relationship to real rates2. Both factors may continue to support gold prices. The rate environment is unlikely to change, given the stance by multiple central banks to lower rates and turn policy overly accommodative to combat sluggish global growth concerns. Additionally, the geopolitical issues are unlikely to go away either given the uncertainty around trade, Brexit, and ongoing strife in the Middle East (e.g., Iran) and Asia (e.g., Hong Kong).
Picking sector winners and losers in trade uncertainty
US-China trade negotiations continue to be a random walk. The threat of tariffs and Chinese Yuan devaluation point to a prolonged environment of trade and economic uncertainty. The US-China trade relationship impacts a broad range of US businesses and their overseas operations, driving market sentiment. However, dispersions between sectors and industries exist. Taking a moment to get under the hood and look at exposures is a good way to find opportunities to pivot to those areas that are potentially less impacted by negative developments on the trade front.
1. Technology: Avoid companies that have high revenue exposure to China or have supply chains that are heavily dependent on Chinese exporters.
Key takeaway: Not all technology runs through China. Software and IT service companies, for example have lower revenue exposure to China and are less dependent on foreign supply chains.
2. Financials: It's no secret that financials have underperformed recently, driven by falling yields and curve flattening on the back of a negative economic outlook, but insurance companies have shown greater resilience. Insurance stocks have historically been less sensitive to yield movements and less volatile than companies in other financial industries3. In addition, financial firms’ businesses and operations are less exposed to tariffs and global trade. From a fundamental perspective, insurance companies earnings growth and sentiment have been strong as well4.
Key takeaway: For investors who favor financials’ domestic-oriented business amid trade uncertainty but want to mitigate negative impacts of falling interest rates, the insurance industry may be an ideal place to be.
3. Rate-sensitive and economic non-cyclical sectors: For some sectors, trade tensions don't matter much and low interest rates may actually help. Utilities, real estate and consumer staples had the most negative beta to 10-year treasury yields, benefiting from lower yields. Consumer staples and utilities are typically non-cyclical and have low revenue exposure to China. Although some inputs, such as agriculture goods, of consumer staples businesses are imported from China, the value of Chinese imports in this category accounted for less than 4% of the total imports. Consumer staple companies can also replace Chinese imports with domestic or other countries’ supplies at lower costs5. Real estate is buoyed by central bank easing and recent strong earnings sentiment.
Key takeaway: Consumer staples and utilities could provide a cushion during an economic slowdown as people need to buy their services and products every day. Real estate is also likely to find new life if interest rates stay lower for longer. Real estate companies can take the opportunity to deleverage and refinance into low rates making their balance sheets stronger. That means these companies could be more resilient than they have been in prior slowdowns. All three sectors currently yield more than 30-year treasuries, providing a source of income in a low-rate environment.
Picking winners and losers late in the cycle is never easy. However, there are a few guideposts that can help investors make choices. Pivoting away from areas that are closely tied to China is an easy one. Dialing up exposure to favorable factors or noncyclical parts of the economy can also support portfolio performance if the economy slows down.
For more insights on how to think through market moves, continue following SPDR Blog. For quarterly in-depth macro, fundamental, and technical data on sectors and industries, check out the SPDR Sector Dashboard as well as our SPDR Chart Pack.
1Source: Bloomberg Finance L.P., as of 8/6/2019. The last nine market downturns: Dot-Com Meltdown: 2/29/2000–3/30/2001; September 11 Terrorist Attacks: 8/31/2001–9/28/2001; 2002 Recession: 2/28/2002–8/30/2002; Global Financial Crisis: 11/30/2007–3/31/2009; Sovereign Debt Crisis I: 4/30/2010–8/31/2010; Sovereign Debt Crisis II: 2/28/2011–10/31/2011; Debt Ceiling Crisis: 7/22/2011–8/8/2011; Brexit: 6/22/2016–6/27/2016. Q4’2018: 9/28/2018–12/31/2018.
2Based on monthly returns for the spot price of gold and the generic US Inflation Government Bond from 19891999 to 2019 the correlation is -0.12.
3Source: FactSet, as of 6/30/2019. Based on 3-year beta sensitivity to 10-year treasury yields and S&P 500 Index.
4FactSet, as of 8/8/2019.
5Source: Office of the US Trade Representative, as of 12/31/2018