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From Macro Outlook to Investment Strategy: Part III

The third installment of BNY Mellon Investment Management’s series on investible themes under the Trump administration looks at the prospects for greater market volatility in the wake of policy and economic risks.

By Jamie Lewin and Alicia Levine


In the first two installments of our three-part series, we discussed the broad economic policy pivots embraced by Trump administration and the emerging investible themes of global reflation, inflation and rising rates. In the final part of our series, we look at the third of these investible themes, uncertainty, greater market volatility and the specific investment strategies investors should consider in 2017.

Uncertainty and Greater Market Volatility

Policy and economic risks abound. The pace of rate increases, fiscal implementation and effectiveness, USD trajectory, populism, potential trade disruptions and geopolitical tensions are all sources of tail risk. Most glaringly, the Trump administration intends to dilute the U.S. commitment to international institutions and global integration after 70 years of post-war leadership. This shift is likely to produce an unstable international climate where previously trusted institutional channels are less effective in lessening cross border tensions.

These policies are a clear source of volatility to markets. With the inability to place probabilities on process or outcomes, the market is entering a period of “radical uncertainty.” This ambiguity could magnify downside risks to asset market globally.

Investment Strategy Implications

This environment yields a range of possible investment actions investors should consider in 2017. BNY Mellon Investment Management believes investors should properly evaluate whether the preconceived investment risks inherent in their asset allocations can be compensated given the anticipated market environment. Of the risks that are typical of most investor portfolios, we focus on those that are most likely to adversely affect investors’ portfolios if unaddressed in a period of increased market volatility and uncertainty.

Assumed Correlations

Proverbially referred to as the only free lunch in investing, diversification, and its effectiveness as an investment risk management tool, depends on the degree of correlation between the asset classes and strategies that comprise investor portfolios. Typically, the greater the level of correlation across a portfolio, the lower the overall level of diversification. In and of itself, low or high levels of portfolio diversification represent neither desirable nor undesirable outcomes, as the context of the overall investment objective of the portfolio needs to be considered when making this assessment. For example, foregoing diversification in favor of certainty of income for an income seeking investor may be an optimal trade-off. Nonetheless, what remains paramount regardless of the investment objective is that, where diversification benefits are sought, understanding and managing the inherent variability in correlations is vital from a risk management perspective. The evolving policy environment has the potential to destabilize correlations both within and across asset classes relative to the recent investment environment. Incorporating this emerging risk into the design of a portfolio is an important consideration today.

Possible actions to mitigate this risk include embracing a more dynamic approach to asset allocation, to anticipate and manage the impact of unstable asset class correlations and volatilities. Investors should also embrace asset classes and strategies that have a structurally lower correlation relative to that of the incumbent asset in their portfolio, in order to lower expected volatility without compromising on target income or returns. Solutions include certain alternatives and multifactor based investment strategies that adopt different weighting schemes to control for the dominance of equity risk in an overall portfolio risk.

Uncompensated Market Risks

At a time of heightened policy uncertainty, with the possibility that left-tail risks dominate market sentiment, and with elevated market valuations for certain equity and credit markets, the preconditions for a correction in risk assets are firmly in place. This is not a forecast, but simply a statement acknowledging the existence of risks that could adversely affect the income generating, capital growth and/or capital preservation goals. Investors tethered to these risks via their allocation to either passive strategies or active strategies which are closely managed relative to passive indexes should consider adopting a more unconstrained active approach which can avoid some of the drawdown risk implied by current market conditions.

Possible actions to mitigate this risk include allocating unconstrained active equity and fixed income strategies whose risk profiles can diverge significantly from their representative benchmarks. This approach allows for the possibility of limiting market derived tail risk without necessarily giving up expected returns.

Jamie Lewin is Managing Director and Head of Product Strategy, Alicia Levine is Director of Portfolio Market Strategy, both at BNY Mellon Investment Management.

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