Investing amid the risk-off turn in markets

The S&P 500 fell 4.8% last week, delivering its worst weekly performance since June and reversing its early-September gains. The main setback came on Tuesday, after US CPI data for August cast doubt on the Federal Reserve’s progress in curbing inflation. On a month-over-month basis, core CPI rose 0.6% compared with 0.3% in July.

Markets are fully pricing a 75-basis-point hike at this week’s FOMC meeting. Fed funds futures are pricing a peak of 4.45% by April next year, an increase from expectations of a peak funds rate of 4% as of last Monday.

Recession fears were stoked again on Friday when delivery firm FedEx Corp pulled its earnings forecast, citing signs of weakening global demand. This followed disappointing economic data from the US earlier in the week. The retail sales control group, which is the portion of retail sales that flows directly into GDP estimates of personal consumption expenditures, was flat in August against expectations of a 0.5% rise. The Atlanta Fed’s GDPNow tracker moved down to imply annualized growth of just 0.5% in the third quarter from 1.3% previously.

The risk-off mood in markets has left some investors seeking refuge in cash. Fund managers increased average cash balances to 6.1% in September, according to a survey by BofA Global Research.

But we advise against retreating to the sidelines, especially given the drag on cash from high inflation and the challenge of timing a return to markets without missing out on rebounds. Instead, we recommend a selective approach to adding exposure:

Seek parts of the market that are more resilient to slower growth and above-target inflation.

• While losses were broad-based last week, value stocks outperformed growth, with the MSCI World Value index falling 3.1% versus a 5.3% decline for the equivalent growth index. So far in 2022, value has outperformed growth by 15 percentage points. Historically, value has done better than growth in periods when inflation has been above central bank targets. While we do expect that the Fed will ultimately prevail in its effort to control inflation, price increases will remain above the central bank’s 2% goal for some time. We also favor sectors that are less vulnerable to recession risks, such as consumer staples and healthcare. Both sectors have outperformed the broader market by around 8 percentage points this year.

Take advantage of volatility.

• High levels of macroeconomic and geopolitical uncertainty are likely to keep markets turbulent in the coming months. The VIX index of implied US stock volatility, at above 27, is consistent with daily swings in the S&P 500 of around 1.7%. However, investors can adopt strategies both to mitigate volatility and even take advantage of it. One way of reducing volatility is to switch outright exposure to structured investments on the same underlying investments, adding a degree of capital protection. Such strategies allow investors to stay invested, reduce downside risks in their portfolios, and participate in potential gains if markets rise. In addition, investors can utilize a high volatility environment to generate yield across currencies, commodities, and equities.

Hedge funds can be an effective diversifier, performing well in falling and volatile markets.

• Select hedge fund strategies can help build defensive market exposure or reduce risk, as they tend to exhibit lower sensitivity to global markets and include a focus on risk management and downside mitigation. In the first eight months of this year, the HFRI Fund Weighted Composite index fell just 4%. That compares to a slump of 19% in the MSCI All Country World index and a 16% drop in the Barclays Global Aggregate Bond index. Macro hedge funds returned 9.3% this year through end-August, mostly driven by strategies based around commodities, developed market fundamental discretionary, and quantitative trend-following. These funds often have the flexibility to flourish in an environment of choppy or falling markets.

So, we advise investors to avoid the temptation to retreat to the sidelines. Instead, investors should position portfolios to perform well in a variety of potential scenarios.

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