Four principles to keep on track in slippery markets

We won’t see the real economic impact of Draghi’s QE until 2016
GLOBAL markets have served up an avalanche of events in 2015 so far – from a plunging oil price and euro, to rallying government bonds; from the removal of the Swiss franc floor, to the shock election results in Greece. It looks as if European markets will be setting the tone for global risk appetite – for now at least.

Last week, European Central Bank president Mario Draghi announced a €1.1 trillion quantitative easing (QE) programme, pledging to purchase €60bn of investment grade-rated securities each month from March this year until September 2016. This new programme is large enough to bring about an easing of financial conditions and to create significant wealth effects (whereby an increase in asset prices boosts demand in the economy). However, due to the lag in monetary policy, we can’t expect to see the bulk of the economic impact until 2016.

CONTINUED SUPPORT
From a shorter-term, more tactical perspective, Draghi’s announcement is the latest confirmation that the Swiss National Bank’s decision to abandon the Swiss franc cap does not reflect a wider shift among central banks to reverse their policies. As such, the underlying environment of low oil prices, low government bond yields, and improving economic growth – in developed markets in particular – should continue to provide a supportive backdrop for global equities.

While the market’s preliminary reaction to Draghi’s plan has provided a marginal boost, a sustained bout of QE will continue to pressure the euro, and also provide another tailwind for Eurozone equities. European growth may still be weak, but European firms will now enjoy an enviable combination of a highly competitive currency, falling energy prices, and record low government bond yields.

STAYING IN CONTROL
But the road ahead will be slippery. So how can investors protect themselves in this chilly climate and stay in control? As recent events have shown, sticking to a disciplined investment process is even more important in this diverging world. Investors wanting to keep warm will need to adhere to four basic principles:

First, remain well-diversified. Individual price moves have gotten larger as consensus expectations have narrowed and policies diverge. For investors seeking to sidestep uncompensated volatility, it will be critical to avoid over-exposure to any individual asset, asset class, or region. Investors should also consider diversifying into alternatives.

Second, rebalance portfolios regularly and systematically. A disciplined approach to rebalancing a portfolio toward a target allocation will allow investors to systematically “buy on dips” and “take profits” without falling into behavioural traps, which often lead even professional investors to buy too late or sell out at the bottom.

Third, seek the shorter-term opportunities on offer in our diverging world, but do so in a measured way, keeping the primary focus on the long term.

Finally, avoid commodity and significant foreign exchange exposure. Research shows that, over the long term, commodities and foreign exchange add to portfolio volatility without contributing commensurately to returns. Therefore, although tactical opportunities will arise, strategic commodity allocations should be avoided, and currency exposure should be hedged. Both the recent sharp decline in the price of oil and copper and the violent moves in currencies give credence to these long-term studies.

While we wait for sunnier times to bring a thaw, these four principles are likely to prove essential for any investor wanting to avoid a frosty outcome.

Bill O’Neill is head of the UK investment office at UBS Wealth Management.

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