By John Lunt, Lunt Capital
News surrounding financial markets have become increasingly noisy. An abundance of forceful and loud opinions seems to permeate online and on-camera media, creating the possibility of investment paralysis or the loss of the ability to hear the actual symphony of economies and markets. Access to information and data is no longer a differentiator, rather the ability to cut through the noise and focus on the most relevant sounds has skyrocketed in value.
The noise is sometimes understandable when we recognize that economies and financial markets are complex systems. The impact of decisions (ranging from public policy to corporate strategy) may only become apparent with a significant lag. While “noisy” market pundits claim to have the answers, it is less clear that they are attempting to answer the most relevant questions.
From a big-picture economic perspective, the U.S. economy continues to move forward. Short-term recession risks appear remote, and unemployment remains historically low. De-regulation and tax-cuts have created momentum within the economy, although debate rages about the sustainability of the fiscal tailwind. The Federal Reserve continues on its path to higher rates, with a consensus the Fed Funds rate will be at least 1% higher by the end of 2019. A flat yield curve has elicited endless handwringing over potential inversion, but the likelihood of higher rates across the curve has increased. Dormant inflation is showing signs of life as we look towards 2019.
The decibel level around the recalibration of global trade is deafening. I spent time this past summer in Argentina, Chile, and Peru. I visited with government officials and representatives from the stock exchanges in each country. Our discussions universally highlighted a sensitivity on behalf of foreign governments and investors to anything that would slow the wheels of global commerce. The current recalibration is exposing inefficiencies in long-standing economic frameworks for governments and markets across the globe. In general, U.S. markets have higher valuations than most foreign markets. Under current policy and prospects, this may be justified. However, a discount on foreign assets has the potential to provide a relative advantage for select international markets over the next cycle. Market valuation has historically been a poor variable for timing market moves, but valuation provides context for long-term asset allocation decisions.
This big-picture overview highlights an increasing divergence in global fiscal, monetary, and trade policies. In our view, policy divergence increases the possibility of asset class, country, sector, and factor dispersion. In additional to the obvious asset class diversification, this backdrop points to the increasing importance of strategy diversification. We always reserve the right to change our views as new information emerges. As we cut through the market noise, we are focusing on five ETF allocation themes as we finish 2018:
- Decrease Market Risk, Increase Strategy Risk. Returns in a portfolio come from a combination of market risk and strategy risk. ETF Investors have the ability to utilize “rules-based passive” in combination with traditional active in order to lessen dependence on market-cap beta. This over-arching theme may be applied within each asset class.
- Fixed Income: Shorten Duration, Go Active, Include Floating Rate. Recent moves higher in yields is reminding fixed income investors about the importance of the duration decision. There are now a variety of ETFs that are capturing the increasing yield on the short-end of the curve. Navigating rising rates points us to the welcome addition of active fixed income strategies within ETFs.
- Alternatives: Utilize Strategies for Participation and Protection. While discussion around alternatives frequently focuses on alternative asset classes, we recognize the value of alternative strategies within traditional asset classes. The ETF evolution has brought hedge fund replication including long/short, merger arbitrage, and managed futures strategies in transparent and cost-effective ETF wrappers. Also, the emergence of ETFs with “go to cash” overlays within the ETF itself are valuable tools within an asset allocation.
- International Equity: Policy Dispersion Favors Deliberate Exposure. We have long championed the importance of looking beyond traditional international equity benchmarks. Policy divergence has the potential to drive meaningful dispersion across countries. An international allocation with deliberate exposure to specific countries, industries, and factors seems warranted.
- S. Equity: Embrace Factor Rotation™. Academic and industry research has highlighted the long-term value of factors, including Momentum, Quality, Value, and Volatility. While long-term factor performance is strong, each factor experiences seasons of outperformance and underperformance. The innovation of Factor Rotation™ offers the potential to capture dispersion within and across factors at a time when many portfolios are overweight traditional, market cap weighted equity beta.
As market noise increases, the potential for investment behavioral mistakes increases in like proportion. The discipline to lower or occasionally turn-off the volume adds to the likelihood of investment success. This helps train our investment “ear” to the sounds that really matter. Despite the noise, there has never been a time with more or better ETF instruments that can be used to play in the symphony of asset allocation. Its time for investors to listen to the beautiful sounds that come from increased asset class and strategy diversification.