The calm before the storm?

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    William Hobbs & Antonia Silcock 22 June 2014

Volatility feels uncomfortable in the short run, but should we worry about it? Does it meaningfully alter our hoped-for investment destination? The best protection remains a diversified portfolio and a steady focus on your investment horizon.

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The return of volatility

The word volatility tends to have negative connotations for investors. In particular, many private clients understandably associate higher volatility with the potential for greater losses or, at the very least, the risk of more uncertain returns. In reality, this is only really completely the case in the short term. Over medium- or long-term time horizons, volatility may be only very loosely connected to investment performance or risk.

Theory will likely be of little immediate consolation to investors when volatility does return to more normal levels. However, although some returning volatility across asset classes will make the investment ride less comfortable, it is unlikely to make the destination any different in the mid-to-long term.

The most likely source of that rise in volatility remains the normalisation of central bank policy in much of the western world. Emergency-level monetary policy in the US in particular has, for many, reduced the need to insure portfolios against future volatility. Similarly, the Federal Reserve (Fed), acting as a guaranteed buyer in an increasingly supply-constrained market, has encouraged relatively serene Treasury markets – a calm that has infected other corners of the fixed income complex.

It obviously doesn’t have to be monetary normalisation that spurs volatility higher, the reality is that it could come from any number of sources. The potential for a messy unravelling of the Middle East’s borders – drawn in the post-WW1 carve-up – will remain a serious threat for a while yet. China’s property market correction is deepening, raising the so far still-digestible probability of an economic accident for the world’s second-largest economy. The eurozone crisis still smoulders – a description that significantly understates the situation in eastern Ukraine. These are just some of the items that are already in investors’ in-trays; a more thorough risk assessment would go on for several more pages.

Figure 1 shows a graph depicting how SAA volatility is not far below the rolling trend.

Nonetheless, we still see the world economy as roadworthy and capable of sufficient forward momentum to digest tighter monetary policy and make the slanting of portfolios towards risk assets the most likely profitable strategy – investor risk appetite and financial personality permitting. We explore some of the fears around the recent low-volatility across asset classes and what that might mean for returns.

Minsky moment?

Hyman Minsky won renown for his observation that periods of calm are often followed by periods of instability. His work drew on the ideas of Austrian-School economists, such as Friedrich Hayek, on business cycles. Collapsing asset values in the wake of a period of investor and/or consumer hubris have come to be known as ‘Minsky moments’. Minsky’s theory around financial crises hinged on the idea that, in the good times, excess private-sector cashflows find their way into increasingly speculative investments. When the resulting bubble inevitably bursts, banks and lenders are forced to tighten credit availability, even to solvent companies, which in turn leads the economy to contract. Economic history is dotted with examples: from the tulip that could have bought you a luxurious house in 17th-century Amsterdam, to the three square kilometres of Imperial Palace grounds in Tokyo that could have theoretically bought you the state of California in the early 90s. Regular readers will know that we remain on the look out for signs of such economic hubris, but as yet see little proof of private sector excess. Emergency-level monetary policy is starting to look dangerously inappropriate for the UK economy, where incoming retail sales, house price and employment data are all pointing in the same direction. However, for much of the rest of the world and, most importantly, the US, we see few signs of the private sector excess, at the aggregate economy level, that would warrant Minsky’s attention.

Large parts of the fixed income market around the world look expensive on any measure of valuation you choose to look at, and equity markets in the developed world continue to punch through to all-time highs. However, we still expect most bonds to be paid back at par, while equity market valuations look less alarming than the price charts they refer to.

If anything, there remains a backlog of opportunities still to be made good after the worst decade of US growth in half a century. These are most visible in housing and capital spending, but they extend across households and businesses. As we’ve pointed out before, these opportunities exist because growth in productive potential has likely continued all along, as it usually does.

Figure 2 shows a graph displaying cash and short maturity bonds with an annualised rolling 3 year volatility. Figure 3 shows developed market equities with an annualised rolling 3 year volatility.

Equities and volatility

Equities are usually the most volatile liquid asset class by far, offering the biggest risk of loss or scope for profit. As a result, for asset allocators, the key call will probably always be how much stock to own. Figure 3 shows that, while annualised three-month rolling volatility for developed market equities is below trend, it is not as far below the same rolling-average measure as short maturity bond and cash markets for example (Figure 2).

Our call on equities is getting more difficult – the cycle is maturing

Our call on equities is getting more difficult, not because we expect volatility to rise from here, but because the cycle is maturing. Valuations are no longer obviously cheap and interest rates are likely to rise before too long, as noted above. As borrowing costs across the bond yield curve rise, the present value of the forecasted cashflows of the corporate sector will shrink in value. This tends to mean that further gains will likely have to be focused on rising or solidifying earnings expectations rather than valuation multiple expansion.

Even so, we still see room in this cycle for equities to appreciate further. The world economy looks set to continue to provide enough scope for the corporate sector to cover its fixed costs with revenue growth. Prospective growth remains a function of as-yet unsatisfied investment opportunities and a still robust outlook for consumption in much of the developed world (driven by falling unemployment, burgeoning confidence and improving credit availability).

Equity markets in the US and continental Europe still look the most appealing in the world. The large-cap UK index will likely remain constrained by its heavy commodity weighting (although this may be a boon in the short term) and, with the continuing absence of meaningful bottom-up reform in Japan, we would advise benchmark-aware investors against straying too far from the benchmark weighting.

In emerging markets, we continue to favour the export-focused economies which have the most to gain from a more vibrant corporate capital-expenditure picture in the developed world. Indices in Korea and Taiwan remain our preferred plays, as they have for several years.

At the sector level, it will likely be the consumer-facing and housing-related stocks that find the going hardest in a rising interest rate environment. Meanwhile, banks and life insurers probably have the most to gain from a more normal monetary environment. Some of this is already priced in, but there may be more to go on both sides of this trade, as suggested by our current recommended sector tilts (Figure 4).

Figure 4 shows a table detailing equity sector strategy, relative to GICS sectors. Figure 5 shows a graph of spreads widened on the taper tantrum.

Fixed income and volatility

The reaction of various fixed income asset classes to last summer’s ‘taper tantrum’ – the moment when investors were forced to rapidly reappraise their expectations for the path of monetary policy normalisation – is perhaps instructive in how we might prepare portfolios for the real thing.

More often than not, interest rates rise in response to an improving economic backdrop…

More often than not, interest rates rise in an economy in response to an improving economic backdrop and the accompanying increase in risk appetite. As businesses and consumers spend a higher proportion of their income, lower savings ratios can begin to squeeze money rates and bond yields higher. Central banks preside over this, and effectively rubber-stamp the process with their own policy rates, but they are not usually the prime movers of it.

So it follows that investors should expect the higher-risk, more-volatile segments of the fixed income space to outperform the traditional safe havens such Treasuries, Gilts, Bunds, cash and short-maturity bonds in what we expect to be a difficult time for all parts of the fixed income complex. However, Figure 5 shows that when interest rate expectations rose aggressively from June last year, risk appetite initially declined markedly, with spreads between Treasuries and corporate credit, junk bonds and emerging market debt widening appreciably. As an immediate response to monetary normalisation, this is perhaps understandable. There are widespread fears that the world’s most-important economy has become addicted to emergency-level monetary policy. With this in mind, many market participants are worried that any interest rate rises may derail what is still widely and in our view, mistakenly, perceived to be a weak and patchy economic recovery. With this in mind, it is certainly conceivable that a higher yield available from some of the lower-risk segments of the bond market could see capital sucked away from the more cyclically sensitive lower-duration issues in the short term as with the ‘taper tantrum’ last year.

However, we think much of the developed world has long been ready for tighter monetary policy and therefore would not see a more appropriate level of interest rates in the US and UK, in particular, as a harbinger of economic catastrophe. As a result, we still suggest that investors are going to be best served by tilting their portfolios towards the areas of the fixed income market where interest rate risk is lowest. Over time, spreads could conceivably go lower within investment grade, amidst an improving economic backdrop, however, in reality there is very little spread cushion left to bite into for the sub asset class. There is relatively more spread to play with in the junk bond market and a firming economic backdrop is likely to see defaults remain relatively low. However, investors should be aware that the size of the market, relative to its daily traded volumes, suggests that the fire exit would be narrow in the event of a serious retreat in investor risk appetite.

Regionally, yields on peripheral European government debt continue to raise a few eyebrows with little to choose between Spain and the US, for example. However, we suspect that peripheral European bonds can continue to trade pro-cyclically versus their more-stalwart US counterparts. They may also find some support from the likely divergent monetary policy trajectories between the two regions over the next few years.

We still expect the next several years to be a tricky time for bond investors – the impressive year-to-date gains in much of the asset class will likely be given back with interest. Figure 6 suggests that three month-rolling volatility has room to rise in government bonds, which would make sense in a world where the Fed’s intentional influence on the space is beginning to ebb. As suggested by our very low strategic weight to the asset class, this dynamic should, over time, see investors demand higher yields for these more normal levels of volatility. Although, we do see rising yields infecting other corners of the fixed income space, some relative protection can still be enjoyed in the areas of the market where interest rate risk is lower.

Figure 6 shows a graph of Government bonds with an annualised 3 year rolling volatility.

As we’ve pointed out, normalising monetary policy is not the only risk facing capital markets and the wider global economy at the moment. Many of these risks could see investors scurrying back to the safety of core government bonds in the short term. However, for the moment, a brightening economic recovery and the potential for inflation pressures to surprise central bankers to the upside, remains the dominant scenario informing how we construct portfolios, both strategically and tactically.

Conclusion

The serene progress of capital markets in the first half of the year, with bonds, equities and commodities all rising in tandem, is unlikely to be repeated in the second half. As interest rate rises loom larger in the US and UK in particular, there will be many who worry that the west’s economic recovery is too thin and frail to stomach tighter monetary policy. This, alongside many other suspected, or even as-yet unknown sources of worry, will likely see more unsettled (and unsettling) capital markets return at some stage soon. However, for investors already appropriately diversified at the asset class and sub-asset class level, the best advice remains to sit on your hands and resist the urge to trade. For those yet to diversify, there is still time, but its running out.