Keep An Eye On Brexit And Trump – But Ignore China At Your Peril

Political and economic influences drive capital markets and, therefore, investor returns.

The markets are – as a result and unsurprisingly – avidly following every twist and turn of the U.S. political landscape and the start of Britain’s divorce proceedings from the European Union.

These obsessions are completely understandable: the United States, the United Kingdom and the EU are three of the biggest and most influential economies in the world, and what is happening in these regions — specifically Trump’s alleged ties with Russia, and Britain and the EU launching two years’ of Brexit negotiations — could ultimately have far-reaching and impactful consequences for the markets.

In recent weeks and months, we’ve seen how investor confidence shifts with such geopolitical factors. Having struck a 23-year low of 9.77 on May 8, the VIX index (sometimes referred to as the “fear gauge”) of implied volatility on the S&P 500 then rose sharply to over 15 during the following 10 days in response to the latest twist in the investigation into Trump’s links with Russia and, to a lesser extent, corruption allegations made against Brazil’s President Temer. It then fell back, spending June hovering between 11 and 10, perhaps as investors reasoned that a presidential impeachment may not, after all, affect U.S corporate earnings very much.

Indeed, while geopolitical triggers may provide us with many more such spikes, it is difficult to see them being sustained (that’s to say a high level of market uncertainty persisting for any length of time). Simply put, broader factors that drive stock markets look set to remain positive and, so, will outweigh most geopolitical worries once the initial shock is priced in. Chief among these positive factors are U.S. and global corporate earnings growth (currently quite strong) and the likelihood of global monetary policy remaining loose throughout the world for the foreseeable future.
One potential trigger for a rise in the VIX that may be sustained — and create mayhem on global capital markets — is a potential downturn in China’s taste for credit.

Chinese credit has helped to underpin global economic growth since the country began its enormous stimulus in 2012. China’s investment in real estate and infrastructure projects also put a protective cushion under emerging markets and commodity prices.

China’s credit splurge peaked in early 2016 and has since continued to decline, thanks to credit controls. Now there is a risk that, in its attempt to curb borrowing, Beijing may tighten monetary policy more than the economy can stand and induce a period of much slower growth. A potentially sharp devaluation could be triggered, that could, in turn, lead to fear of imported deflation in the West. (Remember July and August of 2015?)

In short, the question we now face is not when or if the world’s second-largest economy slows, but the rate at which it does so.

Whether it is more or less extreme, some of the froth will be taken out of global markets. But few investors seem to be making provision for this. Are they distracted by important – but not exclusively so – geopolitical factors, such the circus surrounding Trump’s administration and the landmark Brexit talks?

Moody’s downgrading of China’s sovereign debt rating at the end of May should perhaps have been a wake-up call. Yet, bizarrely, it was met by the markets with a sense of nonchalance. In fact, the region’s main stock indexes actually rose during the week of the downgrade.

I would suggest that global investors, now more than ever, need to be fully diversified across asset classes, sectors and regions in order to safeguard and maximize their portfolios and to ensure they remain on track to achieve their long-term financial objectives.

Perhaps the most common approach to building a diversified portfolio is to consider asset classes that have a low, or even a negative, correlation with each other. By this, we mean assets that have little in common with each other or those that move opposite to one another. For instance, many investors fear that weak oil prices will lead to further weakness for energy stocks such as BP and Shell. A diversified portfolio would, therefore, include sectors such as airlines that benefit from lower oil prices.

For practical purposes, we tend to buy funds that hold a broad selection of stocks, with the greater number of different sectors included the better. The desire to incorporate as many uncorrelated, or negatively correlated, asset classes into an investment portfolio as possible should result in a global multi-asset portfolio. This would incorporate bonds from around the world, including corporate bonds, while perhaps having a bias towards equities. The equity portion of the portfolio would be equally globally diverse.

This investment strategy will help reduce exposure to any one risk, whether it be Brexit, a Trump tweet, a China slowdown, or a company-specific problem that could blow up a narrower portfolio.

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