Time to check your airbags

I recently checked the quality of my cars’ airbags. The exercise was simple, fast and provided immediate comfort that my car would be safe when faced with treacherous conditions. Such conditions are possibly being faced by investors currently. Its timely, therefore, to check the airbags in your portfolio.

Airbags for your portfolio

An airbag in your portfolio works in the same way as an airbag in your car. It cushions against impact. Investors need to take risk in order to achieve returns but it is comforting to know that when that risk makes for a bumpy ride there is some cushioning support to at least provide some offset.

The most obvious form of cushioning comes from diversification. The chart below shows annual returns for Australian bonds and Australian equities. In the past 25 years there have been five episodes of serious downturn for equity investors. That equates to one every five years on average. On each occasion, an allocation to bonds would have cushioned the impact, even in 1994 when both the bond and equity markets sold-off together.

Wouldn’t cash be a better airbag?

Over the 25-year period, bonds have averaged an annual return of 6.9% while cash averaged just 4.8%. So while cash would have worked as a cushion, the risk-adjusted return at the overall portfolio level would have been lower.

Just how effective diversification is as an airbag for your portfolio depends on the asset allocation. The importance of asset allocation cannot be underestimated:

“On average, 90 percent of the variability of returns and 100 percent of the absolute level of return is explained by asset allocation.” Roger G. Ibbotson

In other words, asset allocation is as much about risk management as it is about return management. Your allocation between different asset classes will help you achieve your target return while at the same time managing your risk through diversification.

Uncertain times

It may seem like we are deep in uncertain times right now but the reality is we are always in uncertain times. In the 1970s it was oil price shocks, Vietnam, and Watergate; in the 1980s it was the US savings and loan crisis, the ’87 stock market crash, Beirut, and Tiananmen Square; the 1990s saw the Asian financial crisis and the Russian debt default; while the 2000s was all about terrorism and the War in Iraq, the bursting of the tech bubble, the global financial crisis and deflation.

As the table below shows, financial markets have averaged two major tantrums per year in the past 10-years. The lower-for-longer environment that we are now in, and the greater role played by financial markets in the reaction function of central banks, renders underlying market fundamentals such as earnings and economic growth less relevant. Investor sentiment and momentum become more important drivers of the market and these can swing wildly from time to time.

We now find ourselves in the middle of more uncertainty. The trigger this time around is the escalation in the trade war between the US and China.

The greatest concern about the latest hike in tariffs, to 25% from 10% on $200 billion worth of imports from China, is that it hits consumer goods. Consumer goods account for around a quarter of the $200 billion in goods that will be subject to a 25% levy. Given the narrow profit margins many Chinese exporters are operating under, it is highly likely that at least some of the 25% rise will be passed on to US consumers.

Analysis from Oxford Economics shows the latest rise in tariffs will impact growth in China by more than it will hurt US economic growth. That is not to say US growth will not be affected, however. US farmers are feeling the pinch. So far, US agricultural exports to China have fallen by 30%. Bankruptcy claims for farms in the Midwest are up by 43%.

The most immediate reaction so far to the escalation in the trade war is a devaluation of the yuan. It seems likely the Chinese authorities are allowing this to happen as it provides an offset to the higher tariff costs. Care should be taken, however. The authorities in China want to guard against capital flight which could result in a more dramatic, more destabilising devaluation in the yuan. Such was the case back in August 2015 when China surprised with a devaluation sending equity markets lower. Asian equity markets in particular fell 17% at the time.

The market is in a tough position because it was overbought, the positive catalyst from the earnings season is over, the trade war is getting worse, and economic reports are coming in soft. This is far from a disaster but it would pay for investors to double-check their airbags are in good working order. It is also worth remembering that hope (of a trade deal) is no substitute for good risk management.