Through the Clouds: A Clear Strategy for Uncertain Skies
“Ladies and Gentlemen, the Captain has turned on the fasten seat belt sign. We are now crossing a zone of turbulence. Please return to your seats and keep your seat belts securely fastened. Thank you.”
At Verger, we’ve got quite a few frequent fliers in the office. As such, we’ve often considered the parallels between long-term investing and long-haul air travel. Practiced investors and fliers alike have a deep understanding of and know-how to anticipate market volatility and air turbulence. And yet, during the roughest patches, these experiences can still feel a little uncomfortable. (Ask our team members who have found themselves at 30,000 feet during rough skies).
Just as seasoned pilots use their experience and a range of information to set and navigate a flight path, we at Verger carefully construct our investment portfolios. We use a range of ever-evolving information and our extensive experience (as well as the collective experience of our investment managers) to monitor the portfolios, make adjustments, and move forward – all in line with our all-weather and antifragile investment approach.
Like good pilots, our training and experience have prepared us for periods of heightened turbulence or volatility. Rather than react to every jolt, our focus remains on steering through these conditions with the same focus and discipline we have practiced through previous bouts of volatility and market cycles. This resilience helps ensure we stay on course, regardless of short-term fluctuations, and continue progressing toward the ultimate goal of Protecting, Performing, and Providing for our non-profit clients.
Market Review
While Q3 saw strong market returns and positive news that helped clear some of the previously looming dark clouds, the quarter also showed how some investors can behave like nervous fliers reacting to air pockets. Also known as Clear-Air Turbulence, air pockets are very hard to for pilots to detect and can rapidly develop – causing a plane to experience sudden and even violent movements, without the polite pre-turbulence announcement we’re all so used to.
One such air pocket for the quarter occurred in early August, when the Bank of Japan’s surprise interest rate hike led to a ferocious rally in the Yen, a spike in volatility (as measured by the VIX Index), and a sell-off in U.S. equities. However, in very short order, U.S. equity markets rebounded and the VIX declined.
Another air pocket occurred late in the quarter, when the market reacted to China’s fiscal stimulus, which was unexpectedly reported ahead of China Golden Week. Given that many investors were underweight (or short) China, this announcement led to a significant short squeeze rally.
There are, however, other types of turbulence that are easier to anticipate. The Federal Reserve, for example, makes plenty of announcements about “impending weather”. To no one’s surprise, they lowered interest rates by 50 basis points in September, and the market currently seems to be expecting additional cuts of approximately 100 basis points over the next eight months. While the timing and magnitude of future rate cuts is still uncertain, this activity is generally viewed as a tailwind for markets, pointing towards a clearer weather forecast ahead.
Alongside these events, overall market returns were solid for Q3. There was, however, one major difference compared to previous quarters: U.S. large cap stocks did NOT lead the way. While the S&P 500 returned almost 6%, small cap stocks (Russell 2000) returned over 9%. In addition, international stocks (developed and emerging) had gains of 7% and 9%, respectively. Both investment grade and high yield fixed income markets had strong returns as well. Finally, public real estate, buoyed by the interest rate cuts, returned almost 16%.
Source: Bloomberg
As we pointed out in our 2024 Q2 Market Outlook, we have felt that much of the good news for popular growth names (the “Magnificent 7” in particular) has been reflected in prices for quite some time. Indeed, this quarter saw some dispersion among the Magnificent 7 – with only 3 of the 7 stocks beating the S&P 500 and the other 4 in negative territory for the quarter.
In general, we at Verger are pleased to see the broadening of the rally. This is good news for diversified portfolios and helps ameliorate our previously expressed concerns about how a very narrow rally could impact downside risk (specifically, with equity returns so concentrated, any investor disappointment around the small group of growth stocks could trigger a wider market reversal).
Market Outlook
So, what does this all mean going forward? In short, we think it’s as good a time as any to be taking a long-haul flight, but we will make sure to stay seated with our seat belts securely fastened. There are several possible turbulent events that are easy to see coming (think, the U.S. presidential election, the expectations around interest rate cuts, levels of future inflation, and continued geopolitical tensions). There are also likely surprise events that could trigger heightened volatility – similar to what we saw this quarter.
When it comes to declining interest rates, for example, there isn’t necessarily a high-confidence weather forecast to rely on while plotting the course forward. While companies can benefit from lower interest rates and potentially lower borrowing costs, there can be additional factors at work. For example, if interest rates are declining because the economy is slowing, then what is the impact on corporate earnings? Per the chart below, during prior periods with significant declines in interest rates, corporate profits also saw significant declines. For a market that is already quite richly valued, this is a potential concern for investors.
Source: Societe Generale, Bloomberg.com
When it comes to current market valuations, we feel it important to point out that many equity investors appear to be betting on a U.S. economic soft landing. While this may turn out to be accurate, we see potential risks if this scenario does not play out as expected. Per the chart below, U.S. equities have not been this expensive as of the first interest rate cut in at least 60 years. If the economy does enter a recession, the downside risk to U.S. equities could be surprising compared to past downturns.
Source: Marlin Capital
In other words, while we are pleased to see a broadening of the market rally and economic data pointing to a soft landing, we are not convinced that it’s safe for the Captain to turn off the fasten seat belt sign.
Market Opportunities
Given our outlook, we believe that it is as important as ever for investors to have a broadly diversified portfolio. At Verger, we pride ourselves on our nuanced approach to asset allocation and diversification, where we focus on underlying exposures rather than traditional asset class labels.
As pointed out above, we view U.S. equities as currently expensive. One recent opportunity to diversify our equity exposure comes in the form of publicly listed real estate in emerging markets. As most investors are aware, emerging market equities have significantly underperformed U.S. equities over the last 10 years. In addition, real estate in emerging markets has performed much worse than broad emerging markets, due in large part to the impact of rising interest rates. We believe this has created an opportunity.
Urbanization is a powerful secular trend that is highly correlated to economic growth and rising incomes, especially in emerging markets. Per the chart below, a relatively small increase in GDP per capita (seen here from the first to the second quartile) can lead to a notable rise in the urbanization rate.
Source: The World Bank, The United Nations Population Division, investment manager proprietary research
With rising urbanization rates come potential real estate opportunities. We have recently partnered with a manager who has deep knowledge and experience in these markets and has constructed a high-conviction, public real estate portfolio that is diversified across emerging market countries and property types. This portfolio contains approximately 15 - 20 positions at what the manager believes are attractive valuation levels that are significantly below replacement cost.
As always, we’ll continue to search for this type of opportunity – one that allows us to capitalize on long-term secular trends and market dislocations.
Closing Thoughts
Some frequent fliers recommend rhythmic breathing to calm the nerves during in-flight turbulence. We, however, during periods of market volatility, prefer to repeat our mantra: Protect, Perform, Provide.
At Verger, we don’t just expect turbulence, we prepare for it. Having a disciplined, all-weather strategy is key for enduring the temporary emotional discomfort we all experience during jolts of volatility. We know that even with a clear weather forecast and solid flight path, storms can develop quickly, and air pockets can appear without warning. This is why our investment process is focused on finding a balance between participating in market upside and protecting on the downside.
All investments involve risk, including possible loss of principal.
Not all strategies are appropriate for all investors. There is no guarantee that any particular asset allocation or mix of strategies will meet your investment objectives. Diversification does not ensure a profit or protect against a loss.
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