This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on July 4 - 10, 2016.

Investors have to make more contrarian calls and remain nimble to generate higher risk-adjusted returns in a highly volatile investing environment. They should avoid investment strategies that follow market momentum and adopt a more contrarian stance instead to take advantage of market swings, according to Peter Warnes. 

“We have seen a lot of market moves driven by very extreme positioning and asset classes. Everything you get is very much oversold. For example, some of the mining stocks that were up by more than 50% since mid-January have fallen back,” he says. 

“This is driven by extreme pessimism or optimism. So, we have to be in a position to take advantage of something like this. We have to be more nimble and unconstrained.” 

Warnes, senior managing director of Portfolio Solutions Group International, which oversees more than 100 Manulife Asset Management asset allocation portfolios representing more than US$120 billion, is referring to mining stocks such as Anglo American plc and Glencore plc. The two major mining players survived the commodities collapse last year and have seen their share price (as at June 27) rise 183.94% and 77.98% respectively since the sharp drop on Jan 8. BHP Billiton Ltd, another big mining company based in Australia, saw its share price edge up 25.48% to A$27.23.

“Investors have to be more contrarian this year to take advantage of the market swings. It is not an easy task, but it is a reality that investors must face,” says Warnes.

“[Following the market] momentum has been a very successful strategy for a number of years. But I would suggest that going forward — I am not going to say that momentum won’t work — we have to be a bit more contrarian in the way we think and more tactical in managing money.” 

Warnes says investors could keep an eye on emerging market equities that have very low valuations as there could be some upside potential if the Chinese economy stabilises.

“I think people tend to get carried away by excessive pessimism. In the past, people would ward off an asset class and not want to touch or even look at it. But that asset class sees an outperformance later and those people realise that things have changed and are less bad,” he says.

“Emerging market equities, broadly speaking, is an area that people just don’t want to touch. Like the mining companies, there was a huge squeeze in share 

prices in mid-January and in November and December last year — you couldn’t get anyone to buy into one of these companies. But they all went up very sharply.”

In terms of valuations, the Hong Kong H-shares are worth looking at, says Warnes. “If we are right on the stabilisation of China in the next quarter or so, then I think it is fair to say the H-shares could perform quite well. They have very low valuations and very little expectation has been built into the share prices. They will be direct beneficiaries of the China stabilisation.”

Warnes is not painting a rosy picture of the Chinese economy. In line with his view that the global economy will not fall into a recession, he is positive on China and expects it to stabilise going forward amid the transition to a consumption-driven economy. This will be an added incentive for investors to look at H-shares. 

“We are likely to see a stabilisation in next quarter’s economic data. We have seen some policy risks and fiscal policy responses from the China government. There were monetary policy changes such as the cut in the reserve requirement ratio. But our view is that we should see some improvement going forward and things will get less bad,” he says.

Warnes does not foresee a one-off sharp depreciation of the renminbi this year and suggests that investors focus on the gradual liberalisation of the currency. “There is always a lot of discussion on currency risks. In hindsight, yes, some of the communication involving [monetary] policy could have been handled differently. But we have read some of the commentary by the People’s Bank of China and I think the transparency is improving,” he says.

“We should think more about the renminbi liberalisation after its depreciation. And we think the bank’s issue now is more about managing a basket of currencies against the US dollar.”

US equities remain defensive

Warnes says US equities is a defensive asset class under such an economic backdrop. “We think US equities are quite defensive as we do not foresee a recession in the US. This is despite their valuations being quite rich compared with other developed markets and certainly its profit margins are under pressure. It will be more difficult [for US companies] going forward.

“But having said that, we like that US consumers are very resilient. And they make up 70% of the country’s economy. The labour market continues to recover and is getting close to full employment. The housing sector also looks reasonably healthy. Generally, we see a soft manufacturing sector, but we don’t see much weakness elsewhere.”

Warnes says there could be some downside for the Bank of Japan in hitting its inflation target. But there could be some diamonds in the rough in its equities market. “I think growth in Japan may be pretty tepid and wage growth has been slow. We are still interested in the country, but it is more micro story in terms of equities.”

Warnes says Malaysian equities will very much depend on stock picking and there could be an advantage in terms of currency earnings looking purely from the perspective of the ringgit’s fundamentals.

“If I look at our range of funds, for example, they produced strong returns and generally beat their benchmarks last year. It is really about individual stock opportunities here. The spread of return between individual stocks and the market can be quite high,” he says.

“In terms of currency, I do not have a very strong view. But if you are able to look at the currency purely in terms of its fundamentals, I think it looks pretty attractive. You can stretch your investment further if you are a domestic investor investing overseas. But again, I do not see the ringgit increasing dramatically.”

As at June 27, the ringgit was trading at RM4.10 against the US dollar, up 8.02% from its low on Sept 29 last year.

Meanwhile, Warnes says gold could serve as a diversifier, but it should only be a minor part in the portfolio. “The problem is that there is no yield. Many professional investors like ourselves don’t understand what really drives gold prices, though we think it has a lot to do with interest rates. It is sensible to have some of it for diversification.”

Gold spot prices have increased about 20% (as at June 27) to US$1,315.75 per ounce from US$1,098.68 at the beginning of the year.

In terms of diversification, Warnes says he and his team have been using exchange-traded funds to gain access to different countries and sectors. This strategy also provides them with better liquidity to enter and exit the markets.

“The negative thing about it (the ETFs) is that you lose that active potential return, which is based on the manager’s skills. But by using this strategy, we can buy into markets and sectors we don’t have access to. It gives us much wider choice,” he says.

“We largely invest in US ETFs as they give us much better liquidity. When you go in and out of a [unit trust] fund, it can sometimes disrupt the [prices] of existing funds [and affects your returns]. But we can go in and out of an ETF very quickly. It is extremely useful for us to do a tactical trade. We can also use ETFs to diversify risk if we are concerned about a manager’s investment style.”

Focus on absolute returns

Given the backdrop of low interest rates and inflation, investors should measure investment risk by looking at asset classes that provide absolute returns rather than relative ones.

“In the past, when we talked about risk, we often talked about it relative to [the risk of] a benchmark or tracking error. Now we have to think about the risk relative to the probability of making a loss,” says Warnes.

For instance, buying into US treasuries could be the safest investment even though they provide lower returns for investors. But in an uncertain global economy, investors could make a loss in terms of risk-adjusted returns if interest rates go up and bond values come down.

“Investing in 10-year US treasuries is a low risk investment and is very sensible. But at some point, the risk, given where yields are, could be losing money. It is not happening today, but we need to have a different mindset,” says Warnes.

From an asset allocation point of view, investors should be aware of the correlation between bond and equity prices in the current economic landscape. While bond and equity prices have had a negative correlation, they turned positive in August last year and prices of both securities went down. This made it challenging for fund managers seeking diversification.

“We have been used to negative correlation for quite some time. But there was a six-week period in August last year when equities and bonds positively correlated and both went down. It was a nightmare scenario for fund managers,” says Warnes.

“This exceptional period could be caused by market concerns about the devaluation of the renminbi and at the same time, a potential rate hike in the US. It was very unusual. Yes, there is a risk that correlation may change over time and government bonds may not be the diversification asset class we have seen in the past.”

However, Warnes says the chances of this happening are quite slim unless the world economy moves into a real deflation environment. “Most likely, there won’t be a deflationary environment — unless there is a panic and concerns about central banks heading in one direction [and the real economy going in the other] and there are credibility issues for the central banks.”

He also warns about political risks that might be hard to price in, such as a scenario where Donald Trump is elected US president. The Economist Intelligence Unit (EIU), an independent business within The Economist Group that provides forecasting and advisory services through research and analysis, has rated Trump winning the US presidential election as “one of the top 10 risks facing the world”.

The EIU says, “[Trump] has been exceptionally hostile to free trade, including notably Nafta (the North American Free Trade Agreement), and has repeatedly labelled China a currency manipulator.”

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.