The US equity market wrapped an incredible year with the S&P 500 Index up over 31%, the highest annual return since 2013. Most of these gains came in the fourth quarter of the year with US equities rising close to 9%. This sentiment has continued into 2020 despite heightened political uncertainty. While consumer stability and committed central banks will likely continue to sustain the global expansion during 2020, uncertainty lurks in persistent geopolitical issues.
The Case for a Strategic Low Volatility Allocation
Elevated economic policy uncertainty has reached its highest level in over two decades reflecting continued US-China conflict, an unfinished Brexit and the upcoming November 2020 Presidential election; however implied volatility as measured through the VIX remains at its lowest level since 2017. Is this divergence sustainable? At some point we believe volatility will rise as these measures typically converge over time. Similar to buying insurance, the best time to consider entering into a low volatility allocation is amidst low realized market volatility.
EXTREME DIVERGENCE BETWEEN POLITICAL UNCERTAINTY AND IMPLIED VOLATILITY
Source: Bloomberg, 1997 – 2019. Global Economic Policy Uncertainty Index with Current Price GDP Weights. The index, a widely followed poll designed by three US economic professors, tracks the frequency of newspaper articles that contain a trio of terms pertaining to the economy, policy and uncertainty. It can include broad economy-wide conditions and specific economic conditions of a particular industry. VIX based on CBOE Volatility Index.
The Case for Income Appreciation
Equity markets have delivered remarkable returns in the decade since the Global Financial Crisis. Going forward, investors may face a decade of more modest returns given a starting point of elevated valuations, low interest rates and moderate economic growth. This provides a case for less reliance on capital appreciation and a greater effort to lock in total return through income. Cash flow diversification is one possible solution should investors face lower returns going forward. Sectors such as Communication Services, Utilities and Real Estate source over half of their total return from dividends rather than capital appreciation.
DECOMPOSITION OF TOTAL RETURN
(% DIVIDEND CONTRIBUTION VS % OF CAPITAL APPRECIATION)
Source: Bloomberg, Standard & Poor’s GICS Sector Classification. 25-Year Annualized Return proportion dividends vs capital appreciation contribute to overall total return as of December 31, 2019.
Maintaining dedicated strategic exposure to sectors with low historical betas, such as Utilities, Consumer Staples, Communication Services and Real Estate may serve to offset episodic volatility shocks while helping to lock in a greater proportion of total return through income.
10-YEAR HISTORICAL BETA
Source: S&P 500, GICS Sector Classifications, eVestment. Market beta relative to the S&P 500 Index over the 10-year trailing period ending December 31, 2019.
The current market environment is an opportune time for investors to rebalance portfolios away from cyclical, high beta stocks, and diversify into defensively oriented sectors with stable sources of income which can lower overall volatility and provide additional sources of return amidst moderating economic growth.
This material is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or QS Investors, LLC to enter into or arrange any type of transaction as a consequence of any information contained herein. QS Investors, LLC does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of QS Investors, LLC, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The views expressed in this document constitute QS Investors’ judgment at the time of issue and are subject to change. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. This document is only for professional investors. Investments are subject to risks, including possible loss of principal amount invested.
QSCR-18981 (January 2020)