Why Volatility Might be the New Normal

24 Jul Why Volatility Might be the New Normal

We began the year by reflecting on the fact that 2017 saw extremely low levels of volatility and that complacency might be the biggest threat as Investors became used to the momentum trade only shifting prices upwards.

An idle observation of market performance so far this year would lead to a conclusion that this upward trend continues. Indeed to the end of June, markets have generally produced positive, albeit slightly anaemic, growth in 2018 although that does mask the return of market gyration.

The year started off well but mid-February saw a rise in volatility that we had not experienced in 2017. The largest sell off or correction was just 3% last year, when it is not untypical to see 10% plus corrections. So it was in February, when generally positive news from the consumer-driven US economy in the form of accelerating wage growth, led markets to predict rising inflation and bringing forward the prospect of higher interest rates. The reaction to this news was slightly perverse. When interest rates rose last year, markets saw that as a welcome sign of policy normalisation. So can we conclude that something else was at play during February and March this year?

We have seen the rise of the robots in investment markets, with some commentators estimating that 70% of the US stock market is now being traded by algorithm and with the rise in passive investment instruments, the trend is very much your friend and becomes self-perpetuating as higher asset prices, particularly in constituents of major indices, drive demand from the index trackers and trend-following machines. This “melt up” was certainly evident during 2017 and therefore when the reverse happens it can result in exaggerated movements which means the sell-off becomes worse than that actually warranted. So low volatility, machine thinking and interest rate expectations aside what else has affected markets this year?

The UK, as measured by the FTSE All Share, has seen a moderate increase since the start of the year at 1.69%. The UK economy switched from being the fastest growing of the major developed economies in late 2016 to the slowest by the end of 2017.  Indeed the trend across all 45 economies monitored by the OECD is positive, with all growing and expected to continue to do so in 2018 and 2019, a situation that has historically been very rare.  However, it is predicted that a number will experience a slowing growth rate throughout 2018 and 2019. The UK is expected to deliver subdued growth over the course of this year with some uncertainty in consumer confidence, although there is no doubt that retail spending will be boosted by the unusually warm weather and England’s good, if ultimately unsuccessful, World Cup run.

The outlook for the UK economy remains particularly uncertain, made worse by the resignation of both David Davis and Boris Johnson, as well as the perceived threat of further resignations or disruption to the Brexit process. There remain many critics of the government’s approach regarding the shape of the future relationship with the EU – Mr Trump amongst them, and clearly a lack of confidence in the direction of Theresa May’s current plans. At the time of writing the UK Stock market has fallen slightly and Sterling has weakened.  The outlook for our currency is important given our experiences since the referendum and the oft quoted link between a cheaper currency and the fortunes of our FTSE100’s exporters and overseas earners.

It would appear that, with Brexit uncertainty and a lack of support from a further weakening currency, there is little in the way of a catalyst to drive outperformance from the UK equity market at this stage. We trimmed our exposure modestly in February to reflect that fact and positioned slightly towards a more global approach. That said our allocations to UK equities remain significant and there is some evidence of valuation support in that the current PE ratio of the UK market is below recent highs and the long term average, as well as trading on a discount to US equities not seen since the global financial crisis.

In January we commented on the fact that Trump has eventually begun to push through some of his pro-business promises in the US. Not least of which is an increase in the rhetoric around protectionist policies. Protectionism can be defined as ‘shielding a country’s domestic industries from foreign competition, by the imposition of tariff or non-tariff barriers to international trade’. Section 301 of the US trade Act of 1974, allows the president to take any appropriate action against a foreign government if it violates an international trade agreement or is unjustified, unreasonable or discriminatory.

At the time of writing those section 301 tariffs account for approximately $50bn, which represents roughly 2% of China’s $3.2tn total exports, not sufficient to really have a material impact. Clearly though if this trend escalates there could be a more significant impact on global growth. But it is not all bad news and there are some grounds for optimism. The African Continental Free Trade Area (AfCFTA) covering 44 African states was recently agreed and has the potential to create the world’s largest free trade area. China’s “One Belt, One Road” project to develop trade links, will no doubt look to increase their already significant links with the African continent.

Turning back to the US, to the end of June, the market, as measured by the broader S&P 500, has produced a marginally positive return. Trade war talk and the inflation/interest rate outlook have weighed on markets in the States so far this year and driven volatility upwards. Financial markets are closely watching economic indicators and with the US expansion now lasting almost nine years, not much shorter than the longest ever expansion (10 years, from March 1991 to March 2011), there is some risk, albeit low, of a recession in the world’s largest economy. Recent tax reforms and increases in government spending are likely to keep momentum within the US economy but increasing government budget deficits and a rise in US Federal Debt as a proportion of GDP would set alarm bells ringing for investors.

Elsewhere Global Equity markets have been mixed with China embroiled in, if not an actual trade war, then certainly a war of words and some confusion around each other’s intentions. Despite the headlines, the macro impact has been minimal, particularly on the two main players. Where more material damage is likely to be done is within emerging markets, which are heavily reliant on trade with the two global economic superpowers, but also whose fortunes are inextricably linked to the US Dollar.

Emerging markets have suffered so far this year with a strengthening Dollar and trade concerns taking their toll, but again as a result, those markets do offer a valuation discount versus the developed world and if global trade activity does strengthen then emerging markets will see the benefit.

Property, particularly UK commercial property, is a favoured position within CDC portfolios and the strong performance seen in 2017 has continued into 2018. As we saw in 2016, UK property funds are sensitive to the Brexit outlook and this has led fund managers to either avoid or restrict exposure to those segments most likely to be affected. An example of this is Central London office space, which is heavily weighted towards financial companies, has been removed altogether from one of our funds. Instead the emphasis is on retail warehousing, data centres and regional office accommodation. With high street retail, and especially restaurant chains, suffering some high profile bankruptcies, the pressure on landlords can be significant and going forward appears to be one of the key areas best avoided. As ever, we attempt to diversify and the inclusion of a global approach within our property exposure has begun to add value. Overall, we would expect a modest return from our property exposure moving forward, with a focus on rental yields rather than asset price growth.

Finally, our least favoured asset class for some time has been Fixed Interest. Whilst not being fully weighted here has represented a headwind for some time, we have more recently started to see the benefits of an underweight position in bonds. 2018 has been difficult so far for bond markets as a whole. Government bonds are likely to struggle in the face of interest rate hikes, although do possess some defensive characteristics in a “risk off” environment. Uncertainty has fed through into corporate bonds where valuation and risk concerns have increased. High yield bonds remain relatively attractive as long as the buoyant economic picture prevails. Overall we see equities and property offering better return opportunities than fixed interest markets but we would be foolish to abandon the asset class altogether given the diversification benefits and potential defensive qualities they offer in times of uncertainty.