5 considerations when volatility strikes

As we begin a new year, investors may be taking some time to reassess their portfolios and establish expectations for the road ahead. If any lesson can be drawn from 2019 - with its sudden shifts in the U.S.-China trade war, the U.K.’s Brexit drama and global monetary policy - it’s that investors should expect the unexpected.

Time will tell what surprises will greet investors in 2020, a presidential election year in the U.S. But despite political and economic uncertainty, investors can take steps to prepare for the inevitable twists and turns that will surely drive market volatility. Here are five things to consider for the year ahead.

1. U.S. equities. Patient investors can do well in election years

As in any presidential election year, politics are sure to dominate news headlines in 2020. And with impeachment proceedings looming over Washington and debate raging over health care policy, this election cycle is shaping up to be especially contentious.

Investors may have strong preferences for one candidate or political party when it comes to the direction of the country, but when it comes to the direction of markets, history suggests that the election outcome will make little difference. A look back at every presidential election cycle since 1932 shows that U.S. markets have consistently trended upward after presidential elections, rewarding patient investors - regardless of who occupies the White House.

“Presidents get far too much credit, and far too much blame, for the health of the U.S. economy and the state of the financial markets,” says Capital Group economist Darrell Spence. “There are many other variables that determine economic growth and market returns and, frankly, presidents have very little influence over them.”

To be sure, investors can expect heightened market volatility this election year, especially during the noisy primary season. But election-related volatility can produce select opportunities. For example, pharmaceutical and managed care stocks have recently come under pressure amid political criticism of private sector health insurance. That, in turn, has resulted in some attractive company valuations for investors who believe that a government takeover of the nation’s health care system isn’t imminent.

“Investing during an election year can be tough on your nerves,” explains portfolio manager Greg Johnson, but it’s mostly noise and the markets carry on. Long-term equity returns are determined by the underlying fundamentals of individual companies.”

The bottom line: It may be better to stay invested than sit on the sidelines.

2. Not all dividend payers are the same

Election-related news won’t be the only concern weighing on investors in 2020. With the U.S. economy in late-cycle territory and the direction of U.S.-China trade relations not yet resolved, investors may be worried that a downturn is on the horizon. While a recession may not be likely in 2020, it’s never too soon to prepare for rough seas ahead.

To do this, many investors may instinctively pursue a more defensive approach, shifting toward so-called value-oriented investments. But the value label can be misleading: Not all value-oriented investments have acted defensively during recent periods of stock market volatility.

Instead, investors may want to focus on dividend-paying companies, which have historically played an important role in helping to mitigate equity market volatility. However, not all dividend payers are equal, or sustainable, so selectivity is essential.

Using the S&P 500 as an example, between 20 September 2018, and 30 November 2019, a period of trade-related volatility, companies with above average credit ratings outpaced those with lower ratings. What’s more, dividend payers with above average credit ratings outpaced those with lower credit ratings and companies that paid little or no dividends.

“I steer clear of companies that have taken on too much debt,” notes portfolio manager Joyce Gordon. “Companies at the lower end of the investment-grade spectrum can struggle to fund themselves in a recession, increasing the risk that they might cut their dividends.”

Companies with solid credit ratings that have paid meaningful dividends can be found across a range of sectors. Some examples include UnitedHealth, Microsoft, Procter and Gamble, and Home Depot.

3. Not all the best stocks are in the U.S.

Non-U.S. equities rose in 2019 but have now lagged the S&P 500 Index eight times in the past decade. This remarkable dominance by the U.S. market, driven by innovative tech and health care companies, has raised questions about whether it still makes sense to maintain exposure to international stock markets.

In fact, it makes more sense than ever if you consider how dramatically the world has changed under the influence of free trade, global supply chains and the rapid growth of multinational corporations. “Where a company gets its mail is not a good proxy anymore for where it does business,” explains global portfolio manager, Rob Lovelace, which invests in companies all over the world. “The debate over U.S. versus non-U.S. stocks made sense at one time. But the world has changed, and investors need to change their mindset as well.”

Even during this past decade of U.S. dominance, many of the best stocks each year have been found outside the United States. Over the past 10 years, most of the top 50 stocks were non-U.S., even though the U.S. index did better overall. In 2019, 37 of the top 50 stocks were based outside the U.S.

It’s about selecting companies, not indexes. In a year when political pressure has weighed on many U.S. health care companies, Japanese pharmaceutical giant Daiichi Sankyo was one of the top returning stocks. Likewise, Kweichow Moutai, far from a household name outside of China, became the world’s largest spirits company by market value after its stock nearly doubled in 2019 (through November 30).

4. With U.S. corporates expensive, consider other sources of yield

U.S. credit markets have enjoyed stellar returns. The hunt for yield has put investment-grade and high-yield corporate bonds on track to deliver double-digit gains in 2019. Will the good times continue?

History shows that, with valuations at these levels, corporate credit has tended to lag or only modestly outpace U.S. Treasuries. For investors, this suggests corporate credit may offer limited “extra” return potential for the risk entailed.

That’s important because many investor portfolios have a heavy exposure to credit that may leave them vulnerable in today’s late-cycle economic environment. Holding too much high yield is a particular concern.

Rather than providing diversification, lower quality bonds have tended to suffer amid weak equity markets. After such a strong run in U.S. high yield, investors could consider emerging market bonds. Although they can be volatile, they offer similar income potential to high yield - often with lower correlation to equities.

5. Don’t let uncertainty derail your long-term investment plan

Sudden and steep market declines can unnerve even the most experienced investors. That is understandable. Worried investors inevitably will be tempted to take action in their portfolios to avoid pain. But while it is not easy, the best course is to keep calm and carry on.

This impulse isn’t confined to periods when stock prices are falling — it’s equally tempting when stocks are rising. Just as some investors are inclined to reduce equity exposure following a market decline, others are reluctant to maintain stock investments during a rising market because they worry that a correction might occur.

But maintaining a well-balanced portfolio may be the best approach in any market environment. Consider that since 1999 the largest intra-year decline in the S&P 500 has averaged 15%, but has ended in positive territory 15 out of 20 calendar years. As a result, a hypothetical initial investment of $10,000 in the stock market, as represented by the S&P 500, would have grown to an ending value of more than $31,000 as of November 30, 2019.

Although volatility can be unnerving, it also can represent further investment opportunity for patient, long-term investors.

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