We are also starting to see the effects of slower growth reflected in corporate earnings – last week, both Bank of America and IBM reported some disappointing results, which negatively impacted the markets.
Fear and volatility on the rise
Even for those companies that are showing improvements in earnings, in most cases earnings growth is coming from cost containment rather than from improved revenues and profits.
For much of the past few months, stock market volatility has been relatively muted, but we are finally starting to see that change. The horrific events in Boston contributed to this trend, but even before the bombings occurred investors were reacting to a weak first quarter GDP report from China and signs of slower growth in the US.
In response to signs of slower growth, investors are starting to become more defensively positioned and are growing more nervous about the state of the markets. One way this can be measured is by looking at the Vix Index.
Until recently, it had been trading close to a multi-year low of 11, signalling widespread complacency. Last week, however, the Vix spiked to 18, which is closer to its historic average.
In the present environment, we would continue to suggest that investors overweight equities, but we also think it makes sense to consider a more defensive portfolio positioning. That said, we would be careful about rotating into classic defensive areas of the market such as the utilities and consumer staples sectors, both of which look extremely expensive.
We would also be cautious about small-cap stocks, which look more vulnerable in times of slower growth and higher volatility. Instead, we would stick with our recommendation to focus on mega-cap stocks (which have recently been outperforming).
Problems with short-term gold view
In fixed income markets, we would also re-emphasise our favourable view toward municipal bonds.
Stocks are not the only area of the market that has been more volatile lately. Investors have witnessed a violent sell-off in gold prices over the past couple of weeks. From 9 April through 15 April, gold fell by more than 17%, although prices have since recovered a bit (the precious metal is now trading around $1,400 per ounce).
In the near term, we do not have a strong view about the short-term direction of gold prices and cannot say whether gold has hit a bottom. Determining valuation levels for gold is notoriously difficult since gold does not have a cash flow that can be discounted.
Additionally, it is hard to assess supply and demand dynamics since there is very little industrial or practical demand for gold.
We do believe, however, that there is some benefit to holding small amounts of gold in a portfolio on a long-term basis. As a physical asset and as a historic store of value, gold remains an important source of diversification since it tends to behave differently than paper assets.
Further, gold has historically performed well when interest rates are low, as they are today. To the extent that central banks will be maintaining a stance of accommodative monetary policy, this should be supportive of gold prices.
Given this backdrop, our view is that investors who are holding gold for its diversification benefits and/or as an inflation hedge should continue to do so.
