The yield curve has been rising, but (with exception of the last several days), short term rates have been moving up faster than long term rates. A flatter and perhaps at some point inverted yield curve has typically preceded a recession, as it implies that long-term views of the economy are becoming less rosy.
At the same time P/E ratios of stocks are getting close to all-time highs and commodity prices are rising sharply, which in the past has generally been followed by a recession. In the mean time the Federal Reserve is reducing their balance sheet and draining liquidity from the market.
As of writing, the S&P 500 has again turned officially negative for the year while volatility is higher than it has been for years. European and Japanese stocks are moving right along while emerging and frontier markets are still bucking the trend but also heading in the same direction. Not to sound gloomy but we may be working up to a period of sharply lower returns. How can an investor adjust their portfolio to cope?
What are the risks on the horizon?
I believe we will be going through two distinct periods. First there will be a time of sharply higher interest rates and commodity prices. Meanwhile equity markets start moving sideways as positive earnings surprises fail to excite, and the positive sentiment around their generally good results has to contend with worries about what is to come. Secondly, there will be a time of sharply negative stock returns as a recession brings things back to earth.
In the first period you will want little fixed income exposure except very short maturity and higher yielding bonds. You can complement that with some commodities and selective equity exposure. The latter can for instance be to high yielding stocks, or themes, countries or sectors that still have some life in them or are in an earlier part of the cycle.
In the second period you will want practically no equity exposure at all, keep a significant part of your portfolio in cash and complement that with long maturity fixed income and safe haven assets like gold. You will also be looking to buy the dip.
I believe we have now entered the first period. How long it will last is uncertain, but if the previous two market crashes (2000 and 2008) offer any guidance for the future, we are probably looking at anywhere between 9 months to 18 months (note that the 1989 crash actually happened in a much shorter time span but we are going to work off the assumption that we will face something more similar to 2000 or 2008).
That means that potentially until year-end or even summer 2019 there could be positive returns to be had, but you need to be selective.
How to modify your portfolio
At this point we want to be cautious. But we also don’t want to stand on the sideline until the middle of 2019 if select sectors of the market deliver healthy returns before then. To avoid getting caught out by rising interest rates we will want to reduce our fixed income exposure today and shift into more defensive, less volatile or higher yielding stocks. In addition, some commodity exposure is probably warranted.
Next, over the next 6-9 months or so we want to gradually adjust the portfolio to be recession-ready. That means at least reducing the most risky equity exposure, reducing commodity exposure and adding cash. Once interest rates are sufficiently high it may be a smart move to increase fixed income exposure.
How my model portfolio looks and what changes will be needed
|Category||Name||Max% alloc*||Alloc% today||Alloc% in 6 months||Difference|
|Lower Risk||Rising interest rates||12.5%||10.0%||10.0%||0.0%|
|Lower Risk||The next market crash||20.0%||5.0%||8.3%||+3.3%|
|Lower Risk||Low volatility high yield||11.7%||5.0%||11.7%||+6.7%|
|Higher Risk||Robotics / Automation||9.4%||5.0%||2.5%||-2.5%|
|Higher Risk||Water scarcity||9.9%||10.0%||6.3%||-3.7%|
|Higher Risk||Global tourism||8.1%||2.5%||1.4%||-1.1%|
|Higher Risk||Frontier Markets||11.9%||5.0%||0.0%||-5.0%|
|Higher Risk||Healthcare Innovation||14.0%||12.5%||5.0%||-7.5%|
|Lower Risk||Core Bond||9.0%||5.0%||1.0%||-4.0%|
|Higher Risk||Core Equity||46.7%||27.5%||24.0%||-3.5%|
|Higher Risk||Clean Energy||16.4%||5.0%||2.5%||-2.5%|
|Higher Risk||Modern Agriculture||12.8%||2.5%||0.9%||-1.6%|
|Higher Risk||Trade wars||14.0%||2.5%||0.0%||-2.5%|
|Higher Risk||Late Cycle||16.1%||0.0%||7.5%||+7.5%|
* Refers to our position sizing methodology
- Longer term themes. 45% of the portfolio is currently invested in longer term themes such as healthcare innovation, water scarcity, robotics, clean energy, tourism, urbanisation, modern agriculture and frontier markets. Some of these themes are less diversified and their constituents overvalued. For instance the ICLN ETF in Clean Energy has a P/E of 106 while the HEAL ETF in Healthcare is as high as 102. This clearly needs to be lowered. 6 months target: 20.0%. Since this is a thematic portfolio, we keep exposure to our conviction themes at all times, and once themes become significantly undervalued we want to move back in and pile up the allocation.
- Core equity and bond. 32.5% of the portfolio is in the core equity and bond themes. Both carry higher risk from emerging markets, while the core bond theme has relatively high interest rate sensitivity. I will reduce their combined allocation to 25.0%
- Short-term themes. 17.5% of the portfolio is currently in themes that play in on rising interest rates, a market crash and trade wars. These will be gradually raised to 28.3% as risks intensify. The Late Cycle and Stagflation themes are added into the mix
- Low vol high yield. 5.0% of the portfolio is invested in the low volatility high yield theme. This theme has been holding up well and would likely add diversification in any crash, and I will increase it to 11.7% (its maximum allocation per our sizing methodology)
- Cash. The remainder of the portfolio will be held in cash