We suspected that a rise in market volatility was likely in 2018 – but of course, no-one knew how or when it would play out. That risk seemed very far from investors’ collective consciousness as global stockmarkets roared higher through January in one of the best starts to the year seen in the last three decades – not since 1994 has the MSCI World enjoyed a stronger return for the first month of the year. We found ourselves reappraising (and, luckily, revalidating) our own somewhat cautious investment stance in the face of such strong market momentum.
What had led us to a slightly cautious stance, against a background of the best economic environment in a decade and solid corporate earnings improvements? Stockmarket valuations are on the high side, high enough to warrant some medium-term caution, but this is not a new development, nor necessarily an obstacle to even higher valuations in the short-term. Investor sentiment seemed unusually bullish – the Investor Sentiment Survey carried out weekly since 1987 by the American Association of Individual Investors showed levels of optimism exceeded only a handful of times in the last decade. It’s not always a reliable contrarian indicator, but we have often seen peaks of bullish sentiment in indicators like this followed by periods of below-par equity market returns: as Warren Buffett said, “Be fearful when others are greedy…”.
We were concerned too by the extraordinarily low levels of market volatility, the lowest in a generation or two (until the recent reality check). When markets are very calm and it seems easy to make money, expectations can shift higher and perceptions of what is ‘normal’ can start to recalibrate around the experience of the recent past. Complacency can entice some investors into taking more risk than they should; and low volatility can mean that some investors are taking more risk than they realise. Both factors build the potential for a violent rotation when risks start to materialise and volatility rears its head.
To be clear, there are few near term economic clouds to be concerned about: this ought to be a good environment for corporate profits. We might be mindful of the risk of a market correction, but would put a much lower probability on a deep or sustained bear market. The growth outlook seems well-underpinned for now, with business and consumer sentiment pointing to higher spending, and lead indicators suggesting that there is no recession on the horizon. We might worry, however, a little about some headwinds from higher oil prices, or ripples from China’s housing market slowdown. But these threats seem modest compared to the far deeper concerns that markets have climbed through over the last five years or more. Even so, this benign economic environment does still present some challenges for stockmarkets.
Over the past decade, central banks have taken extraordinary steps to support the global economy and attempt to combat deflation and stagnant growth. The unthinkable has become normal, as central banks cut interest rates to zero (or below) and bought trillions of Dollars of financial assets, mainly government bonds, in a programme of Quantitative Easing (QE). They may claim some success from these actions – financial disaster was averted and the global economy, after several false starts, is back in expansion mode. But now the sands are shifting: a stronger economy – and particularly signs that inflationary pressures are building – encourages central banks to inch towards tighter policy and begin to withdraw QE and gently increase interest rates. This shift presents challenges for investors. QE and zero or negative interest rate policy created clear distortions, dampening volatility, and creating very low bond yields, even negative bond yields in many cases, and not just in the safest havens.
The effects of this unprecedented intervention has spill-over effects across other asset classes. Low government bond yields forced investors to look elsewhere for returns, chasing yield and pushing up prices in riskier bonds and riskier asset classes. That distortion was broadly helpful for investors over the past decade, as it helped to inflate asset prices. However, we need to plan for a progressive shift in policy direction as the next year or two unfolds – and for that shift to quicken if the economy strengthens or inflationary pressures build. The unwinding of QE’s distortions in markets could raise new questions about asset valuations and trigger more bouts of volatility.
Perspective is required. The market volatility of the last few days, triggered initially by stronger than expected wage inflation data in the US unsettling bond markets, is a stark and sudden shift form the dead calm of the last 12 months or so. The one-day moves in stockmarkets were quite large (the US saw the biggest one-day move since 2011), but market behaviour so far has remained quite orderly. Volatility measures have risen, but so far there has been little sign of sustained panic or disruptive effects in other assets, such as high yield bonds or commodities. There may be more volatility to come before the market stabilises, but it seems likely to us that this episode is a correction of high valuations and a sign of markets adjusting to the shifting stance of central banks, rather than the first act of a recession and a deep bear market.
We continue to look for opportunities to deploy some of the relatively high levels of cash we hold in portfolios – cash buffers built to enable the funds to exploit moments such as this. We tread carefully and remain prepared for a further round of volatility, but are selectively buying – both bonds and equities. We are adding to 5-year US Treasuries, where yields have shifted from below 1% in summer 2016 to over 2.5% now, already pricing in a series of future interest rate rises. We are also adding to UK equities, where the recent correction highlights some value reappearing, and allows us to reduce our underweight position.
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