Preparing portfolios for potential volatility

Investors should consider preparing for market risks and potential volatility, despite recent performance that may reflect a broader economic recovery.

“Arguably, we’re starting to see breadth expand in the market, which is in part due to growing expectations for a soft landing,” said David Wong, chief investment officer, managing director and head, total investment solutions, with CIBC Asset Management. 

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While the S&P 500 soared last year on the back of tech and discretionary stocks, sectors such as energy and financials have outperformed this year, Wong said, which is “a bit of a leadership shift.”

The S&P 500 is up about 9% year-to-date, and the more broad-based performance could continue if the economy keeps strengthening and inflation fades, he said.

“At the same time, I think we need to be at least somewhat concerned about complacency in the market, and acknowledge that it’s the unexpected events that really move the markets,” he said.

Risks this year include the U.S. election and geopolitics, Wong said. From a secular perspective, he cited productivity challenges.

Pre-Covid, “we knew that total factor productivity, which is the gains in the economy beyond growth in land, labour and capital, was low for several decades, and the economic picture wasn’t that great,” Wong said. Post-Covid, this low productivity “has been obscured by the massive liquidity created by central banks in response to the pandemic,” and is something to keep an eye on, he said.

Also, as central banks walk the line of taming inflation without sending the economy into recession, “the conditions are there for a return to volatility,” Wong said. “In the near term, uncertainty remains around the surprising resilience in the U.S. economy under the current restrictive [monetary] policy.”

He noted that, since 1980, intra-year drawdowns in the U.S. market have averaged about 14%. “So far this year, we’ve only had about a 2% drawdown,” he said. “So, prepare for the emotional battle when that turns.”

On the plus side for investors, bonds, with their attractive yields, can provide a hedge. With the S&P Canada Aggregate Bond Index yield at about 4.4%, the longer-term return potential for bond investors is more attractive than it’s been over the last 15 years, Wong said.

His stance on equities was “neutral overall from a tactical perspective,” given historically high multiples on the one hand and positive performance on the other.

Rather than underweight risk assets to address potential volatility, he recommended diversification to mitigate the risk of market concentration. The U.S. market, for example, accounts for nearly 70% of the MSCI World Index.

Private equity strategies could fit the bill, specifically those that focus on “profitable companies that can be improved with operational know-how and don’t rely on simple multiple expansion for their case for compelling returns,” Wong said.

And higher bond yields present a “very strong argument for a 60/40 approach that includes global equities and diversified bond exposure,” he said. Such a portfolio allocation over the past 20 years to the end of 2023 had a 6.8% rate of return, he said.

Further, “investors actually get more return per unit of risk simply by combining the assets,” Wong said, referring to equities and bonds. “That’s the power of diversification.”

The 60/40 mix can also be refined with alternative investments.

“These are actually very exciting times … with the number and quality of alternative products … that allow [qualified investors] to access private markets,” Wong said.

This article is part of the Advisor To Go program, powered by CIBC Asset Management. It was written without input from the sponsor.