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LGT Beacon: Navigating fragile markets

January 11, 2017

In 2017 there will be no shortage of political events with a potential to at least disrupt the global equity bull market, like the upcoming Brexit process or the German and French elections. Still, we advise investors to remain constructive and focus on setting portfolios on a robust footing by adopting a long-term asset allocation that includes alternative investments.

Our base case for this year is once again rather benign, with a mix of monetary and fiscal stimuli supporting the global economy and markets. The resulting reflationary effect should outweigh the risks of a disruptive rise in protectionism, while the hunt for yield will keep additional demand for risky investments intact despite increasing valuations. At the same time, we believe financial markets have become more fragile due to fault lines that are increasingly emerging from within, rather than the much-discussed external events.

The latter naturally receive a lot of media and analyst attention and represent the following risk factors:

  • Peak easing: monetary policy is at a critical juncture and is seen as becoming less effective. The negative initial market and macro reactions to the Bank of Japan’s introduction of negative interest rates in early 2016 provides a good example. Responses to the European easing measures since 2015 have also been more muted than the responses to the earlier US programs.
  • Risks can also result from politics (elections, popular votes, social rifts, etc.), geopolitics (terrorism, military standoffs, etc.), and other events (natural disasters, pandemics, etc.).

Nevertheless, the following internal fault lines are generally less appreciated by investors and increasingly important in our view:

  • Shifting correlations: traditional portfolios that rely on simple correlation patterns may be at risk here. Specifically, the prevailing negative relationship between risky assets (such as equities) and safe government bonds may no longer hold in the future, as repeatedly observed after the Federal Reserve signaled its intention to start withdrawing monetary support in 2013.
  • Investor crowding: safe-havens, bond proxies and deflation-trades represent a broad and potentially harmful consensus in-vestment among investors - for if the tide turns, crowded investments may turn out to be anything but defensive.
  • Rising leverage: financial engineering at the company level and rising margin debt at the investor level increases investment risk from two sides.
  • Elusive liquidity: the withdrawal of banks as classic liquidity providers (market makers) and the advent of automated trading programs may overstate liquidity conditions and compound market stress.

Investors should thus prepare not only for more volatility, but also for changing market patterns. With financial markets more vulnerable to dislocations, many traditional portfolios may struggle during difficult market phases, as simple diversification may fail. To achieve a truly diversified asset allocation and set up very robust portfolios, investors should:

  • combine various traditional and alternative risk factors,
  • harvest different sources of alpha in investment categories that rely on skill,
  • and add flexible cross-asset strategies and sophisticated tail hedging programs.

At LGT Capital Partners, we firmly believe the endowment-like approach of the Princely Strategy represents these principles and provides a very good solution to a range of investors - beginning with a long-term strategic asset allocation that accounts for several future economic and policy developments through scenario planning. On the following page, we briefly outline our new adjusted economic and market scenarios and the resulting strategic asset allocation elements for 2017 and beyond.

Read more in the LGT Beacon

Read about the resulting investment positioning changes in our portfolios in the LGT Beacon below. To subscribe to a weekly newsletter, go to subscriptions.

Note: The next LGT Beacon will be published on 25 January 2017.