CIO Insights: 3rd Quarter 2017

Only have 30 seconds? This is what you need to know:

• The year’s third quarter was filled with excitement and events that shook markets, temporarily a few times, but the economy never even flinched.
• Over in the US, wages are increasing at the fastest pace since the global financial crisis. This could slow “real” growth.
• Globally, the economy is still growing but just a little slower. And that’s ok, as long as you are diversified and prepared.
• Diversification isn’t only about mitigating risk-- it’s also about maximising returns and sourcing them from multiple asset classes.

Stellar equity market performance in an eventful quarter

The third quarter of 2017 was certainly eventful. Market participants had to confront a slew of geopolitical events. Then there was the risk of a potential US government shutdown. Investors also had to assess the damages from Hurricane Harvey. Despite all the razzmatazz, growth-oriented assets have been able to clock in impressive gains; between 1st July and 10th October, stocks in Asia ex-Japan, emerging markets, and US technology have outperformed with gross returns of 10.3% to 10.7% (Figure 1).

As reiterated numerous times in past CIO Insights, economic fundamentals are the ultimate drivers of asset class returns that withstand market fluctuations. In last month's CIO Insights, we emphasised that “event risks could extend into the end of third quarter, but their effects on the markets are likely transitory in nature as the global economy is still doing fine."

Figure 1 – Overview of asset class performance

Source: StashAway, Bloomberg

Wage increases re-accelerated, and so “real” growth could slow

Wages are rising in the US and doing so at an increasing pace. The latest average hourly earnings data for September have increased 2.9% on a year-over-year basis. This is the highest reading since the 2008 global financial crisis! Wage growth has clearly re-accelerated since mid-2017 (Figure 2), and is starting to drive headline inflation higher.

In principle, when the relationship between wage growth and general inflation is strong and positive, the labour market could tighten. In such a situation, companies would find it increasingly difficult to hire without offering higher salaries. Although the economy is still growing, its pace has been modest. This means we currently do not have a thick buffer against a pickup in inflation. A moderate increase in inflation can still lower the quality of corporate earnings and hence stock market performance.

Figure 2 – Wage growth adds momentum to inflation

Source: Bureau of Labor Statistics, Bloomberg

Our analysis so far points to a slowdown in “real” growth, which is basically the difference between nominal growth rate and inflation. As shown in Figure 3, real growth is a key determinant of stock market performance. In particular, the relationship between real growth and S&P 500 total returns is strong and positive. This indicates that a slowdown in real growth tends to be accompanied by lower stock market returns, and vice versa.

Figure 3 – “Real” growth a big determinant of stock market performance

Source: StashAway, Bloomberg.“Real” Growth is computed as Industrial Production YoY minus Headline CPI Inflation

Real growth has also been an impressive predictor of major turning points in the stock market. As it stands, it is currently close to historical mean. Due to increasing wage growth, real growth is likely to slow from here. Good news is we have detected no signs of a major reversal; the world is still growing, just a bit less than before.

Build versatile portfolios with multiple pockets of returns (Diversify!)

Despite lower real growth, the silver lining is that there will be alternative pockets of returns. Long-term investors must build highly diversified portfolios that have the resilience to perform consistently regardless of the economic cycle. These highly diversified portfolios must have a good mix of growth-oriented assets (e.g. developed market equities, small-cap growth and technology stocks, convertible bonds), protective assets (e.g. government bonds, high-quality corporate bonds), and inflation protection (e.g. inflation-linked bonds, emerging market equities). Having a strong mix of asset classes can help your portfolio perform consistently when real growth is slowing. The bottom line is that diversified portfolios need to include more than plain vanilla stocks.

Figure 4 - Average impact of a 10% move in MSCI World Equity Index(since Jan-2015)

Source: StashAway, Bloomberg

To illustrate the diversification benefits that you can achieve with StashAway, let’s first examine our portfolios’ exposure to global equities. We will proxy global equities with the MSCI World Equity Index, which is the most prolific global benchmark for equity fund managers. As can be seen in Figure 4, a 10% move in the MSCI World Equities would generate an average impact of 1.3% on the returns of portfolio #1 (most conservative portfolio). As you can see, only 13% of portfolio #1’s returns come from global equities, even though 44% of its funds are invested in growth-oriented assets. In contrast, that same 10% move in global equities would generate an average impact of 3.5% on the returns of portfolio #28 (most aggressive portfolio). So even though portfolio #28 invested 69% of its funds in growth-oriented assets, only 35% (3.5% out of 10%) of its returns are driven by the global equities. To be clear, this does not mean that portfolio #28 is investing 35% of its assets in global equity market. There are other sources of returns at work here for portfolio #28 such as convertible bonds, precious metals and inflation-linked bonds.

Diversification extends beyond arbitrary geographies and asset classes. A thoughtful mix of assets reduce concentration risk and helps create additional pockets of returns throughout economic cycles.

StashAway adopts a highly diversified approach to build resilience into our clients’ portfolios. Is your portfolio prepared for whatever comes next?

This is investing, redefined.