With increased volatility where to diversify tactically within equities and fixed-income?

The global equity market emphasis has shifted from deleveraging of short volatility funds and fears of higher interest rates as manifested by the move in the US 10-year Treasury to near 3% this February, presently to trade tensions and the technology sell-off this March.

Clearly, the risk premium has increased somewhat in the short-term on technology shares due to data collection and privacy issues as well. We expect higher volatility throughout this year.

However, US earnings season will begin on 13 April, which may allow investors to focus on company specific results and consequently, lead to more divergence in performance of shares. For investors who are already overweight on large cap technology shares or do not want that type of concentrated risk, where may such investors look to after the recent volatility?

Unlike the large cap space in the US and China, small/mid cap market returns have not been dominated by a selected group of mega-cap technology shares. In addition, they appear to be more shielded from trade tensions as such companies are likely to have a lower percentage of international revenues on average. In addition, domestic Europe and Japan economic momentum seems to be building up and now appears to be more sustainable, as opposed to the later cycle of the US. Our base case remains no tit-for-tat trade war but the small/mid cap market provides a way to source an asset allocation in equities more sheltered from this ongoing trade tension within the developed market equity allocation. 

As such, after the recent renewed market volatility we would re-examine the Europe and Japan small/mid cap equities and look to start averaging into these strategies, given our recent shift back to a moderate equity overweight view after the February sell-off this year. Keep in mind that an investor may need to be more nimble and should expect returns to be lower this year. Finally, and importantly, small/mid cap shares have moderately outperformed their respective large cap indices year-to-date in Europe and Japan through 30 March, illustrating the diversification effects. While there may be advantages in small/mid cap equities, investors should be aware that small/mid cap equities can be more volatile and usually have higher level of market risks than large cap equities.

In addition, Emerging Market (EM) local currency debts continue to outperform in absolute and relative terms most other bond investments year-to-date. While we do not expect the FX return to contribute as strongly from here, the real yield pick-up is still attractive, especially with any short-term bounce back in the dollar to average into the asset class.