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Volatility & Creative Destruction: Some Pieces of the Larger Puzzle

The President’s Letter at the start of the latest Investment Quarterly from Neuberger Berman, the investment management spin-off from the late Lehman Brothers, looks at US stock market volatility through October, and fits it into the broader business-cycle picture.

President (and CIO) Joseph Amato observes that optimists will look at consumer confidence, which remains high, healthy business activity and hiring, and the 50-year low of the unemployment number.  With inflation “largely under control” it is impressive that gross domestic product is expected to come in at nearly 3% for the year. Optimists, then, will see recent weeks as at most a pause.

The Pessimists

But pessimists will observe that “overly aggressive rate hikes or aggressive trade wars could end things early.”

Regarding the trade war threat, it is worth mentioning that as of Sept. 24, the US had imposed a total of $250 billion of tariffs on Chinese goods, and China had replied with a total of $110 billion.

Elsewhere in portfolios, bond investors are naturally concerned about the policies of the Federal Reserve, the unwinding of its balance sheet (and the balance sheets of other central banks), and higher short rates. All these things are “making US Treasuries less appealing to foreign investors who have to hedge their currency risk.”

We are seeing a long expansion getting old, and it is natural to wonder about the timing of the next contraction. In general, the “environment is likely to be fluid and at times volatile, and requires heightened focus from investors,” NB’s Amato writes.

Asset Allocation

In broad terms, this is how NB sees issues of asset allocation:

  • US Equities—NB has a “neutral” overall outlook for the next 12 months, favoring small and midcaps over the large caps, because the large caps depend more on overseas sales. Further, NB cautions that much of the benefit of the tax cuts may have already been discounted in the stock prices.
  • US Fixed Income—as noted above, NB is concerned about the “headwinds” that investment grade bonds have encountered.
  • Non-US Developed Market Equities—Key indexes have “settled at lower levels” in Europe. This suggests slower growth. On the other hand, the European Central Bank is accommodating. Meanwhile, in Japan, the weaker yen could help with the corporate earnings numbers, and the Bank of Japan is pursuing its yield-targeting policy.
  • Emerging Markets, Equity and Debt—NB has a bullish view on both debt and equity, “despite short-term volatility and negative sentiment related to global trade tensions.” These assets have been oversold, and thus offer opportunities.
  • Hedge Funds—NB also sees value in “uncorrelated, low-volatility hedge funds” which “can provide a thoughtful approach to managing risk in periods of increased correlation.”
  • Private Equity—Private equity (and private debt too) are attractive, given the illiquidity premium and modest mark-to-market volatility.

Amato refers the reader to the cover story in the same issue of the quarterly for a more expansive view of some of these points.

That cover story, “Today’s Seismic Shifts and Their Impacts” says that there are four key secular trends at which investors should look, if they want a horizon that extends beyond the cyclical. The trends are: the debt explosion and its aftermath; the shift toward a multipolar world; the change in the public/private asset balance; and the acceleration of the technological “creative destruction” we see around us.

Creative Destruction

Creative destruction involves things like autonomous driving, the trend whereby algorithms are letting us humans abandon our place at the steering wheel. Who are the winners and who are the losers from this trend? It is, of course, “extremely difficult” to pick the winners. However, accepting the premise that this change is coming helps an investor or manager focus his research. There are established vendors of related products and services that are likely to benefit, whether directly or indirectly.

Picking the winners in the tech-driven race to implement machine-driven transportation could be extremely difficult. However, if you accept that self-driving cars will eventually gain acceptance, then you can focus on researching established providers that are likely to benefit, whether (directly) sensor, software and semiconductor manufacturers, or (indirectly) cloud service providers or wireless telecom operators. In an evolving competitive environment, grasping the difference between fighting or ignoring such a trend and working it into one’s research process “could be a key fact in achieving attractive performance over time.”