Responding to the risk-off turn in markets

Recession fears were fueled again on Friday as delivery firm FedEx Corp withdrew its earnings forecast citing signs of weakening global demand.

This followed disappointing economic data out of the US earlier in the week. The control group of retail sales, which is the portion of retail sales that feed directly into GDP estimates of personal consumption spending, was flat in August, against expectations for a 0.5% increase. As a result, the Atlanta Fed’s GDPNow tracker moved lower, implying annualized growth of just 0.5% in the third quarter, versus 1.3% previously.

The biggest setback for markets came earlier in the week as data cast doubt on the Federal Reserve’s progress in containing inflation. On a month-to-month basis, core CPI rose 0.6% compared to 0.3% in July. That comes ahead of this week’s Fed policy meeting, which is expected to see a third straight hike of 75 basis points.

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The risk-averse mood in the markets has led more and more investors to seek refuge in cash. Fund managers increased average cash holdings to 6.1% in September, according to a survey by BofA Global Research.

However, we do not advise moving to the sidelines, particularly given the strain on cash from high inflation and the challenge of timing a return to markets without missing rallies. Instead, we recommend a selective approach to adding exposure:

Take advantage of the volatility. High macroeconomic and geopolitical uncertainties are likely to keep the markets turbulent in the coming months. The VIX index of US stock implied volatility is above 27, consistent with the S&P 500’s daily swing of about 1.7%. However, investors can employ strategies to mitigate and even profit from volatility. One way to reduce volatility is to switch direct exposure to structured investments with the same underlying assets and add some capital protection. Such strategies allow investors to stay invested, reduce downside risk in their portfolios and participate in potential gains when markets rise. Additionally, investors can take advantage of a high volatility environment to seek returns across currencies, commodities and equities. Click here for more.

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Hedge funds can be an effective diversifier that performs well in falling and volatile markets. Selected hedge fund strategies can help provide defensive market exposure or reduce risk as they tend to be less sensitive to global markets and place an emphasis on risk management and downside mitigation. In the first eight months of this year, the HFRI Fund Weighted Composite Index fell just 4%. This compares to a 19% fall in the MSCI All Country World Index and a 16% fall in the Barclays Global Aggregate Bond Index. Macro hedge funds have returned 9.3% this year through the end of August, mainly driven by strategies based on commodities, developed market fundamental judgement, and quantitative trend following. These funds often have the flexibility to thrive in an environment of troubled or falling markets. Click here for more.

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We therefore advise investors to resist the temptation to retreat to the sidelines. Instead, investors should position their portfolios to perform well in a variety of potential scenarios.

Main contributors – Mark Haefele, Christopher Swann, Vincent Heaney

Content is a product of the Chief Investment Office (CIO).

Original report – Responsing to the risk-off turn in markets, September 19, 2022.

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