Increasing market risk - reducing exposure

From May through August we witnessed and participated in a strong run up in equities and high yield bonds as fundamental macro conditions improved. In early September, the positive market development was interrupted. After a rebound through much of October, the month ended with renewed volatility spilling over into a rebound into November and through the US election. There have as always been several drivers for the change from a positive trend to more volatility, including valuation concerns, earnings visibility, macro numbers in Europe, US fiscal policy, the China-US trade situation, and the outlook for US politics. At the time or writing, the US election result is still not fully clear, although a first take away is that one-party decisive dominance of The Congress and the presidency is unlikely. This is a positive for markets, which do not like the uncertainty associated with political changes. However, the ongoing argument about the legitimacy of the election is adding to uncertainty as it is tainting the credibility of the future president.

To assess the market risk and the probability of positive returns through all off this information, and to do it in a consistent and unbiased way, we turn to our algorithms. As seen in the figure below, the outlook is deteriorating. We have therefore reduced risk by scaling back holdings of equities and high yield bonds from the maximum allocations across our portfolios as and where relevant. Further reductions are a possibility, but we are not expecting a global recession. We therefore also stand ready to add to equities and sub-investment grade bonds if the outlook improves. We have recently been further improving our process for such re-entry. For now, our views and allocation changes can be summarised as follows:

- Market risk has been increasing as the momentum behind the Fed monetary policy easing in declining. Increased global uncertainty around health issues, valuation, US fiscal stimulus and the durability of the recovery have led to declining momentum in both equity and commodity prices, which in turn is adding to uncertainty.

- With both the Chinese and the US economies having moved into recovery phases, we do not expect a global recession, but as signalled by our algorithms the risk-return trade-off has deteriorated.

- We have now scaled back allocation to equities and high yield bonds across the ACCI funds and in our mandates, from their previous peak levels and according to their specific strategies. The proceeds have been invested in government bonds and credit. For a typical balanced strategy this means a reduction from 50% or 60% equities to 30%. In the Global Fixed Income Opportunities fund we have reduced the high yield allocation to 70%.

- In our most cautious and reactive strategies, we have reduced equities to zero. This can seem aggressive, but this is the kind of changes necessary to limit drawdowns as much as possible. Last time we cut risk to this level in the Welzia Global Flexible fund was on the 2nd and 3rd of March, limiting the drawdowns in Q1 2020 to less than 10%.

The Fed’s policy support has been decelerating as credit market momentum declined on the back of gradual increases in government bond yields and moderate spread widening. At the same time equity market momentum has turned from decisively positive to a more mixed pattern of sideways volatility as concerns around valuation and visibility have hurt leading regions and sectors. This is reflected in the algorithm guiding our allocation decisions: these have lost momentum and declined to levels signalling and increased risk of a significant further correction in markets.

Both the Chinese and the US economies have returned to expansion mode and growth is broadly supported. In our algorithms this means that the business cycle trend component remains encouraging with a solid reading of end demand and business confidence. As a result, we are not predicting or expecting an imminent global recession. We also maintain that more policy stimulus is a distinct possibility. This is even more likely than not to appear both in the form of traditional fiscal policy from the US Congress and from the monetary policy side via the Fed. The latter can be expected to be particularly supportive of markets if volatility increases in an accelerating manner. That said, with volatility in equities already high, the effect of Fed policy is less certain than in more calm market. The timing and magnitude of the fiscal stimulus also remain uncertain.

As seen again in recent sell offs, the high yield market is relatively well supported, and we would not be surprised to see the Fed add stimulus via further interventions verbally or directly in this market should they deem this beneficial during future corrections. This, we maintain, makes both the high yield asset class and our Global Fixed Income Opportunities strategy and fund interesting, especially for investor looking for a return above inflation and growth, in a strategy with a very active risk management.

The current earnings recovery represents a noteworthy difference to the situation in late 2016. Back then a spike in volatility into the US election rapidly turned into a renewed forceful market rally benefitting the fund and mandates we managed for the rest of 2016 and all through 2017. While the earnings season is stronger in Q3 than in Q2 2020, we do not have the same broad-based corporate profit recovery established yet as we saw in 2016. This impacts the business cycle component of our algorithms, which is also is weighted down by the still positive, but declining momentum behind the Fed's credit expansion.

In summary, our algorithms do not signal that markets will necessarily collapse, but the risk of a more significant correction has increased, meaning that the risk return trade-off has deteriorating. With the S&P 500 and Nasdaq trading close to all-time highs, we have reduced portfolio risk across our strategies from previous peak levels. That said, government bonds will not be able to provide long term return at desirable levels from here. We therefore also stand ready to increase the equity and high yield allocation again in case of a stabilisation of the outlook. We have further improved the process of decisive reinvestments in recent months.

We will continue to adjust our portfolio positions according to the development in market risk and return potential as captured by the respective algorithms and will keep you updated on an ongoing basis.

We remain available to answer questions via email, phone, and video conference.

Best regards,

Mads N. S. Pedersen, Human Edge Investment Technology

+ 41 765 878 979