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LGT Investorama: Navigating at the borders

22 November 2018

Investing and driving are similar in that the top priority is to avoid accidents. Dry roads allow you to drive faster. When there is fog, snow, or ice, the cautious driver will slow down and be on the alert for sudden, unexpected hazards. Adaptive behavior like this is also important in the financial markets.

Smart investors seek out protection – even though protection comes at a price. Implementing the broadest possible diversification and exercising discipline are key for achieving passive safety – exceptions confirm the rule. Strategic asset allocation (SAA) entails diversification not only by investment class, region, currency, manager, and counterparties, but also according to extreme scenarios that have been well thought through.

The task of investment strategists is often like running a road rally on winding gravel roads – with steep drops on both sides. That is why tactical navigation is essential as an active security element. To master the road rally of tactical asset allocation (TAA), the idea is not to focus solely on what you see directly in front of you or on every individual stone on the road, but rather on the stretch ahead as far as possible, in the curves as well as the straightaways. Unfortunately, the economic fundamentals, which change relatively slowly, are not constantly discounted by the markets. Instead, economic developments are “overlooked” for long stretches of time and then suddenly priced in. Such bumps in the road demand appropriate reactions that still keep track of the big picture straight ahead.

Our assessment of the situation in the rear-view mirror: low-risk stock markets like the current bull run where prices rise over a period of years, encouraging aggressive investing, usually start from low valuations and are supported by expansive monetary policy and unstrained economic growth with no signs of overheating. Currently, we are looking back on an unusually long phase in which all of these conditions were fulfilled in an almost ideal, financially beneficial way. But, according to all the available benchmarks, we are in the late phase of the cycle!

The road ahead is full of risks that are difficult to assess. The global economy is still expanding in general, thanks to the aggressively expansive policy mix deployed around the world since the financial crisis. The cyclical divergence between developed countries and the structurally weak emerging markets is, however, becoming more pronounced – the upward trend is no longer synchronized. The US economy is so strong that it is reaching capacity constraints in terms of energy, commodities and labor (owing to the tight labor market), which is pushing up wages and inflation, though so far only gradually. Central banks are called upon to forge ahead with their monetary normalization, and governments should be under pressure to bring their budgets and debt load under control. A “normal” cyclical pattern would see the bull market to have run its course and more share price corrections, were it not for the Trump administration and its late-cycle fiscal excesses.

There is a demand for leading indicators, especially for ones that are precise and reliable as far as possible. Unfortunately, perfect timing with the help of macroeconomic leading indicators is as unattainable as an ideal stability policy. Political officials, such as central bankers, cannot mechanically fine-tune the economy as if they were engineers. And their target figures – such as growth and inflation rates – do not always react to monetary impulses in the desired manner. On the contrary, there are time delays and feedback mechanisms that are difficult to evaluate in advance. Just like with a radar detector, the challenge with leading indicators is getting the sensitivity right. If they are over sensitive, then false signals predominate, because far too many (apparent) turning points are indicated. In contrast, if they are not sensitive enough, the (correct) diagnosis comes much too late.

The moral for investors is thus not unlike that for drivers and pilots. First of all, do not let yourself be pressured by anything or anyone. Second, it is better to adjust your speed and risk-taking to the situation, realistically considering your own risk capability. And third, at the border between a gradually tapering upward trend and a potentially abrupt reversal, which is where we find ourselves now, there needs to be readiness for courageous steering maneuvers. After a long, almost monotonous move straight upwards, there is now an acute danger of becoming inattentive and changing lanes too late.

Dr. Alex Durrer
Chief Economist

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