How to secure performance in your portfolio?
A V-shaped recovery
Nearly all the fourth quarter losses have been erased. Equities have gained 20% from their December 25 lows at a quite remarkable pace. As an illustration, since 1931, there have been only 6 years in which returns already surpassed 10% by the end of February. The rest of the year then saw either modest additional returns or negative ones (on two occasions).
Nice returns despite fund outflows
These returns have been achieved despite net mutual fund and ETF outflows and in a context of downgrades of growth and earnings expectations. The latter have more than halved in less than 6 months. So, what allowed markets to rise by that much? First of all, share buybacks! Then, animal spirits have been fed by a Federal Reserve U-turn, favourable economic news, particularly out of China, and the prospect of a trade agreement between the US and China.
Equity markets need to take some breath after their steep ascent. There are technical considerations, such as divergences or the level of complacency, illustrated by a record net short position in CBOE Volatility Index futures contracts. More importantly, there are fundamental reasons: economic trends are slow moving, it is only in the second half that it should become apparent that the global economy effectively remains well oriented and that there is even some slight reacceleration.
Moderate upside by the end of the year
Valuations already discount a lot of positives. In a world of moderate earnings growth and with numerous political uncertainties, they are a constraint on the upside potential for equity markets. Hence, we see new highs in the second half only moderately above the ones recently reached. Seasonality observations lead to the same conclusion. Going back to 1950, the 6-month period starting in May delivers an average return of 1.5%, the worst of any 6-month period. The second worst delivers an average return of 2.5% (it starts in April).
In a nutshell: secure your performance
The upside of equity markets is closely tied to the earnings growth rate. The latter is low-to-mid single digit. Portfolios should thus be structured to give some protection while still offering exposure to the moderate upside that we expect in the second half.