"Investors often ask how we are positioned to withstand a market downturn, which potential catalysts we are monitoring, and what will happen in the event of the next volatility spike.
These concerns are especially prevalent in the current environment in which market volatility has been very low for an extended period. Such an environment encourages risk-seeking market behavior and, as a result, some investors are concerned markets are currently vulnerable to an intense risk-off episode like the one we experienced in the second half of 2015. After all, central banks don't have much ammunition left to try to cushion another sharp market downturn.
There is no shortage of macro risks on the intermediate-term horizon, but we don't believe overall risk is heightened today.
Still, macro investors like us are expected by our clients to provide some degree of downside protection in market downturns. But we don't rely on identifying or monitoring catalysts to help us manage our portfolio against market downturns. Why is that?
Chemical Catalysts Provide Insight
Chemical catalysts provide a good analogy to answer this question. As background, I received a degree in chemistry before starting my career in investing. In chemistry, a catalyst is something that starts a chemical reaction—a reaction that likely wouldn't have started without it. For example, the catalyst is a flame lit over gasoline.
The process that the catalyst starts is one that chemists call “energetically favorable.” It takes something from a state of high energy to a state of lower energy. In investing, this process is like prices moving toward fundamental value.
At the same time, the chemical catalyst that triggers the process has nothing to do with the starting or ending state of energy. It's unrelated to the chemical reaction. It comes out of left field, triggers a reaction, and is then unrelated to the process.
Market Catalysts Difficult to Identify Ahead of Time
The same is true for catalysts in financial markets. That's why we don't rely on forward-looking catalysts to manage downside risk.
In financial markets, a catalyst that causes a market price reaction is probably not directly related to it. The catalyst, whether it's a piece of news or another event, might have nothing to do with the markets we're assessing. The catalyst likely doesn't undergo any change related to the market reaction. It comes out of left field, starts a reaction that would have been justified anyway (energetically favorable), then goes away.
A real-world example of a catalyst was observed in Mohamed Bouazizi. Bouazizi was a Tunisian street vendor whose self-immolation in 2010 caused the Arab Spring uprisings. A simple street vendor, who seemingly had no power to cause such an event, became the catalyst for the collapse of multi-generational dictatorships and regimes in the Middle East and Africa.
What this means is that it's extremely difficult to identify a catalyst for a market reaction ahead of time. Even if we were to attempt to identify a market catalyst, we'd likely have it wrong. Being overly focused on catalysts may cause us to be close-minded in all our other fundamental and geopolitical analysis.
How We Manage Risk
Instead, we rely on our “Outlook” view of risk, which is influenced in large part by macro themes, geopolitical scenarios, and game theaters. As part of our investment process, we also assess how big or small these influences are to determine whether or not they may create significant headwinds or tailwinds to fundamental opportunities.
We also rely on breadth and diversification, including diversification from our active currency exposures and non-systematic market risks.
As I mentioned, we don't disagree that a market downturn could come at some point, but our current assessment remains that the overall risk environment is not heightened today. We will continue to obtain exposure to compensated valuation opportunities that we currently observe in markets and currencies—without being overly aggressive or cautious."
Thomas Clarke, Partner