The Three Scenarios That Should Guide Investors

Take into account endogenous economic and financial healing, long-awaited policy breakthroughs and bigger liquidity waves.

If you are adding to your long-term holdings of stocks and other risk assets at current market valuations, you are likely to be betting -- knowingly or not -- on a combination of three drivers of future returns; or you are planning to sell your holdings to someone who is or will be making that bet. Understanding the importance of these three scenarios, both in relative and absolute terms, indicates not only the probability of being right over time, but also the tilts you should be applying to your current “risk-on” portfolio positioning.

One of the main analytical challenges facing investors in today’s unusually fluid world, and there are many, is deconstructing the potential drivers of overall market returns into a small number of actionable and verifiable hypotheses. That means specifying a “reduced-form” equation in which just a handful of explanatory variables identify the conditions under which risk-on investors will continue to be richly rewarded.

One such specification involves following three scenarios that, importantly, need not be mutually exclusive: endogenous economic and financial healing, long-awaited policy breakthroughs and bigger liquidity waves.

With the synchronized pick-up in growth, the global economy continues to heal as improvements in Europe and the emerging world compound trends in the U.S. This helps boost actual economic activity, through higher investment and consumption, while partially reducing the downward pressure on potential growth, lowering concerns about elevated asset prices and enhancing the scope for the orderly normalization of the unconventional monetary policies by the Fed and other systemically-important central banks.

In this first scenario, investors would benefit from being long market indices, and from also concentrating specific company or country bets to situations where there is an overwhelming case for narrow idiosyncratic influences. Under those circumstances, low-cost passive products investing in large public markets will continue to do well.

This gradual healing process can be turbocharged by a meaningful step-up in policies aimed at reducing structural impediments to growth, striking a better balance between monetary and fiscal expansion, lifting pockets of crushing debt burdens and improving global policy coordination. In this scenario, the probability of such policy breakthroughs would increase, though it is far from assured, thanks to the external disruptions to the established political order that have occurred in the last 16 months in France (with the election of President Emmanuel Macron and his new party’s sweep of the National Assembly), the U.K. (with the Brexit referendum), and the U.S. (with the election of President Donald Trump and Republican majorities in both houses of Congress).

In this second scenario, risk-on portfolio positioning benefits from a much bigger layer of active investment management, including one that incorporates a careful identification of the winners and losers from policy actions. This is particularly important when it comes to tax reform, infrastructure, debt reduction, and the balance between new regulation and the relaxation of old regulation.

The third and final scenario in this reduced-form analytical approach is driven by liquidity considerations. Here, the continuous injection of funds into the marketplace by central banks and from the cash-rich balance sheets of highly profitable firms continues to make its way to financial assets in almost all corners of the world. The ability to gain responsive portfolio exposures is enhanced by the proliferation of both passive and active vehicles that offer dedicated and crossover investors the ability to sell volatility and liquidity in a growing universe for both public and private markets.

This last driver has an interesting twist: ample liquidity that entices investors to become increasingly exposed to historically illiquid asset class segments. It’s a tug-of-war that, rather than be addressed through tactical portfolio positioning, requires at least one of the other two hypotheses to also be meaningfully in play.

Then there is the manner in which all of these hypotheses relate to what markets have already priced in. Today’s absolute and relative valuations of asset classes would suggest that investors seem to be strongly expecting at least two if not all of these factors to be in play. And they have been happily betting on this outcome for a while, despite repeated delays in the materialization of these conditions.

This article originally appeared on Bloomberg View.