The opening salvo of a US trade war with China, the first of three to four anticipated rate hikes from the Fed, and a bona fide 10% market correction marked a jarring risk trifecta that surprised many investors in the first quarter of 2018. But a closer look at institutional investor sentiment shows not only has the smart money expected these events, they’ve made critical adjustments in preparation for a market shift.

From the Brexit shock to the Trump upset to North Korean threats to Russian election meddling, there have been a multitude of reasons that geopolitics have topped institutional risk concerns since 2016. But it was during the first quarter of 2018 that politics began to hold sway in the markets.
Institutions recognize that volatility can create dispersion across sectors and securities – in other words big winners and losers. That should prove to be a more fertile environment for active management.
On March 21, US President Donald Trump called for 25% tariffs on steel, aluminum and other exports from China. Fears over what a trade war might mean to stocks triggered one-day losses of 2.4% for the S&P 500 and 2.9% for the Dow Jones Industrial Average and ended in the worst week for markets in two years. Fears were replaced with hope as investors reacted to news reports that the US and China had begun back channel negotiations on trade and the Dow delivered a 669-point gain on March 26 – its third best day ever.

Based on results from our Global Survey of Institutional Investors,1 many institutions have prepared for this kind of event with regional shifts in equity allocations, with 36% saying they would look to decrease US exposures and 33% planning to increase European exposures. Also on the radar screen were increases in emerging market stocks for 27%, and Asia Pacific stocks for 22%.

Natixis Investment Managers Chief Market Strategist David Lafferty says these allocation calls reflect shifting views on geopolitical risk and stability. “Recent history shows greater concern for the geopolitical stability in Europe than for the US. For all the concerns over the effects of populism on elections in France and Germany, wins by Macron and Merkel have been a benign outcome. Hints of a Trump-led trade war with China have focused risk concerns on the US.”

“On top of it all, global stock growth has been a boon for emerging markets. The consensus view is a depreciating US dollar,” Lafferty adds, “making US assets less attractive than non-US.”

Rates raise the stakes
Upping the ante on risk was the Federal Reserve’s announcement of a 25 basis point hike in the federal funds rate in March – the first of three increases anticipated in the year ahead.

While taking longer to materialize in market action, this small increase taps into one of institutional investors’ biggest anxieties. They rank rising rates right behind geopolitics in their risk concerns. Six in ten worry that rate increases will have a negative impact on portfolio performance, and seven in ten see greater volatility on the horizon for bond markets.

After more than a decade of solving to low rates by taking on higher and higher levels of credit exposure, 71% of those surveyed believe that institutions have taken on too much risk to pursue higher yields. How it plays out in portfolio performance may have as much to do with the pace at which rates increase as the amount of the increases. With the economy growing, nominal rates are likely to rise on the back of higher real yields and potentially higher inflation. “This should concern investors,” says Lafferty. “With low starting yields and relatively long index durations, even a modest rate increase could wipe out an entire year’s worth of income from high quality bonds.”

Not surprisingly, institutions say they are first dialing back on duration, allowing them to reduce their interest rate exposures. Many are also looking to alternative investments as a substitute for bonds. Infrastructure (55%), real estate (54%), and private debt (47%) all factor into those that institutional investors say are suited to delivering a stable income stream.

Bubbles won’t break the bank
Asset bubbles and increased market volatility factor into the hand dealt to investors in the first quarter, and both feature prominently among institutional risk concerns. After a witnessing a year of steady gains and low levels of volatility in 2017, investors saw the trajectory continue in January. But then a raging bull market ran into concerns that stocks were overpriced, the economy could be overheating and inflation was ready to run, resulting in a two-week 3,200-point decline in the Dow.

Volatility continued into March and the Dow delivered first quarter losses for the first time since 2015. Volatility in and of itself is not necessarily bad in the eyes of institutional investors. In fact, 59% go so far as to say that the absence of volatility in the previous year was actually cause for serious investor concern.

Unlike individual investors who worry that volatility will undermine efforts to meet savings and retirement goals, most institutions see opportunity in the volatility. They predict 2018 will bring greater dispersion (46%), lower correlations (31%) and a market that favors active management (76%).

Why institutions would rely on active in today’s market is a matter of opportunity, according to Lafferty. “Institutions recognize that volatility can create dispersion across sectors and securities – in other words big winners and losers,” he says. “That should prove to be a more fertile environment for active management.”

In preparation for more volatile times, they’re dialing up exposure to active investments. While the professionals see active as the better choice for downside protection, taking advantage of short-term market movements and generating alpha, they wonder if individual investors have the whole picture. Three-quarters worry that individuals are unaware of the risks associated with passive and that they have a false sense of security about these investments.

The return to risk
While they may be facing a triple threat at the end of March 2018, institutional investors haven’t been taken off guard. Politics, interest rates, and volatility have each factored into their investment strategies since 2016. Now these plans are being pressure tested by real market risks.

1 Natixis Investment Managers, Global Survey of Institutional Investors conducted by CoreData Research in September and October 2017. Survey included 500 institutional investors in 30 countries.

This material is provided for informational purposes only and should not be construed as investment advice.

All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

Unlike passive investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of an active investment to achieve its objectives will depend on the effectiveness of the investment manager.​

Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.

Alternative investments involve unique risks that may be different than those associated with traditional investments, including illiquidity and the potential for amplified losses or gains. Investors should fully understand the risks associated with any investment prior to investing.

Natixis Distribution, L.P. is a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Investment Managers.​