Looking ahead, investors cut risk amid market turbulence

Ring in the new year and wring out the risk! The worst year-opening week on record in the U.S. stock market and renewed turmoil in China has prompted more than a few major investment houses to advise that clients pare back risk in their portfolios.

Two European investment houses — Royal Bank of Scotland and Societe Generale — are calling for sub-$20 oil and a potential 75 percent rout in U.S equities. A J.P. Morgan investment officer recently told clients not to buy stocks on dips but rather sell them on rallies.

Businessman at fork of stone pathway in water
Thomas Barwick | Getty Images

As frightening as the start of the year has been, Russ Koesterich, chief investment strategist for BlackRock, suggests that investors forget about January barometers and the technical data that forecast coming doom in the markets.

"It was the worst opening week on record — that's a fact," he said. "But to suggest that the first week of January is going to determine the rest of the year is more astrology than investment analysis.

"If you believe we're headed into a recession, then get out of the market, but there's no conclusive evidence that that will happen," he added.

Of course, Koesterich isn't exactly bullish on the outlook for U.S. or global stocks.

"We've come out of a period when you could buy the U.S. market and go to sleep," he said. "That's over. You need to be more nimble and precise in your investing now."

Koesterich favors non-U.S. developed markets in Europe and Japan, which on a currency-hedged basis, did significantly better than the U.S. market last year. Both have the tailwinds of more accommodative monetary policy behind them, and both have a good shot of exceeding low growth estimates in the coming year.

Questions, however, abound for every region of the world:

  • Can the Chinese economy avoid a hard landing, and can policymakers there make the transition to open capital markets while avoiding a plunge in their currency?
  • Can emerging markets recover their footing even if commodity prices don't?
  • Can Europe stay on a path of economic union and cooperation despite the stress of the refugee crisis and terrorism threats?
  • Can the U.S. economy continue to show decent economic growth while dealing with the consequences of the rising dollar and higher interest rates?
Tetra Images | Getty Images

For the time being, China is the source of biggest concern and will likely remain a source of systemic risk for several years. And as goes China, so go most of the other emerging markets that have relied on commodity exports to China to drive their economies. That doesn't mean that the U.S. and other developed markets will continue to follow it down.

"If China sneezes, the rest of the world doesn't have to catch a cold," said Ryan Larson, head of equity trading at RBC Global Asset Management. The global exposure to Chinese equities is still minimal, with most of the investment going into Hong Kong-listed H shares rather than in the Chinese domestic market, which was only opened to foreigners in 2014.

However, the turmoil in China clearly has investors worried about risk more generally. "In times of heightened volatility, people use all sorts of excuses to take money off the table," Larson said.

The biggest risk in the global economy is an escalating currency depreciation cycle if China lets the yuan fall too fast. It still has trillions in U.S. dollar currency reserves, but a rapid decline in the yuan may cause other countries to devalue their currencies. "We don't expect that to happen, but it's at the top of the list of things to worry about," Koesterich said.

So where do investors go, and what do they avoid?

Cash. There's nothing wrong with sitting on cash and waiting for the smoke to clear before putting it to work, according to Jeff Saut, chief investment strategist for Raymond James.

"We currently hold a 20 percent cash position," he said. "There's a human need to be active, but sometimes doing nothing can be the best strategy. If investors want to be tactical, they should wait until market indicators are more clear," he added.

"There's a human need to be active, but sometimes doing nothing can be the best strategy. If investors want to be tactical, they should wait until market indicators are more clear." -Jeff Saut, chief investment strategist for Raymond James

Junk bonds, MLPs and TIPs. The early volatility this year has investors fleeing for safety in Treasury bonds, but the landscape for fixed-income investments is bleak.

With rates still near historical lows in the U.S. and still lower in other developed markets, the opportunity for price appreciation is slim across most markets. Analysts expect the yield curve to flatten as the Fed raises short-term rates, but there will likely be negative returns on high-quality bonds if developed economies meet their slightly higher growth estimates for 2016.

"I have a big underweight position on fixed income," Saut said. "High yield is where I'd look for opportunities."

The widening of spreads in the junk bond market has arguably created some buying opportunities, but proceed with extreme caution. Credit and default trends are deteriorating for the energy companies — just under 20 percent of the market — as well as other sectors of the market.

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Another high-risk, high-yield investment that Saut likes is midstream and downstream master limited partnerships that aren't levered to the price of oil. "Avoid the upstream MLPs, but you can buy investment-grade credits and get close to 7 percent yields," he said.

An area of the fixed-income market BlackRock's Koesterich likes is Treasury Inflation Protected Securities, which are currently pricing a 1.5 percent rate of inflation over the next 10 years.

"Inflation expectations have collapsed in lock-step with the price of crude oil," he said. "Outside of energy and commodities, price inflation in the U.S. is firmer than the TIPs market suggests."

Emerging vs. developed stock markets. The decline in emerging market currencies and stock prices may be tempting, but don't jump in yet. Many of the emerging markets will continue to suffer as long as the prices of commodities stay in the tank or fall further.

"There's growing chatter that commodity prices will revert to pre-China bubble levels," said Larson at RBC Global Asset Management. That would mean further double-digit percentage declines from here. "I think we're in the later stages of the cycle, but I don't think it's over."

That being the case, emerging markets are vulnerable in the short term. Koesterich, too, is cautious, but he suggests people make a shopping list of the emerging markets they like and be prepared to invest when the cycle turns. He favors India, Mexico and the Hong Kong-listed H shares of Chinese companies.

How will a China slowdown affect Europe?
How will a China slowdown affect Europe?   

The slower-growing, but marginally improving, developed-country economies are the better bet at this point despite the increased volatility. Larson favors Japan, Europe and the U.S. — in that order. All three markets, including the U.S., still have accommodative central bankers behind them, and all three are showing modest signs of economic improvement.

When it comes to which sectors of the U.S. economy will perform best, Saut at Raymond James likes technology, health care and consumer discretionary stocks.

"The fall in oil prices represents a $250 [billion] to $300 billion tax cut for people," he said. "I think that's created a lot of pent-up consumer demand."

— By Andrew Osterland, special to CNBC.com