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The global economic backdrop – current and expected – remains supportive for risksensitive assets. As ongoing above-trend growth reduces the amount of remaining slack in the economy, inflationary pressures are finally beginning to build, taking inflation back towards central bank targets.
It is entirely appropriate that this combination of robust growth and rising inflation is now leading to changes in policy. The withdrawal of monetary accommodation is one of our major themes and has the potential to impact asset prices significantly.
As central banks remove liquidity from the system, fundamental weaknesses across asset classes and regions that have previously been masked by abundant money are becoming more exposed (Figure 1). We have already begun to see some of these fragilities in certain emerging markets where reliance on external or internal financing is comparably high. Brazil and Turkey are prime examples. While each has its idiosyncratic dynamics playing out and policy responses certainly differ, the commonality is one whereby tightening US dollar liquidity is leading to less generous capital flows into emerging markets.
Many emerging markets have benefitted greatly from the era of cheap money and have enjoyed significant inflows, driven in part by the search for higher yields. As yields elsewhere rise and the opportunity cost of investing in safer asset classes diminishes, the return on EM assets will look less favourable, particularly in economies where there has been a lack of political and structural reforms.
In order to stem capital outflows, several EM central banks have intervened in one way or another. Turkey has raised policy rates aggressively (Figure 2), while Brazil has relied more on the use of foreign exchange intervention.
We continue to expect greater dispersion not only across EM asset classes but also within asset classes more broadly. In terms of investments, this means we like to be more selective in our EM exposures, be that in equities or in fixed income.
As monetary accommodation is removed and fundamentals increasingly drive markets, volatility, both in terms of the variability of asset prices and as an asset class in its own right, will be impacted.
A strong global growth environment is often associated with periods of structurally low cross-asset volatility. Looking ahead, we expect growth will remain strong in 2018. However, we also believe that cross-asset volatility will be sustainably higher than the depressed levels of 2017, which was notable not only for its level, but also for the range of assets it influenced. While a robust growth environment should temper any rise in volatility, the days of ultra-low volatility are probably behind us.
Figure 3 shows the significant jump higher in both US rates volatility and US equity volatility at the start of the year. The sell off in equities and subsequent increase in volatility was driven by a concern that US monetary policy accommodation would be removed faster than the market had initially anticipated.
Perhaps as importantly, tighter US policy has ramifications well beyond its own market. The spike in US equity volatility seen earlier this year generated a broader rise in equity volatility as markets moved in sympathy with the US. Likewise, we believe that higher US rates will foster higher rate volatility across the asset class.
The move higher in equity volatility was exacerbated and prolonged by a change in market structure, whereby losses on short volatility trading strategies intensified equity selling. Alterations in market structure are evident in other asset classes also. This changing market structure can create liquidity vacuums when the market needs it most and therefore can exaggerate market fragilities.
Adding another layer of complexity in navigating markets is the political newsflow which is, one way or another, nationalistic in nature. While we must not dismiss the risks that emanate from trade frictions between the US and other regions, nor those from attempts to break away from a set of common institutions and rules with the latest episode unfolding in Italy as we write, we rather view these developments as volatility events that are to be weathered so as long as they do not derail the global recovery.
It is against this backdrop of more political headlines that we would not be surprised to experience more frequent volatility spikes, if not “mini-crashes”, as central bank support is slowly fading, forcing investors and global markets to regain the ability to price underlying risks across asset classes.
We position our portfolios accordingly by remaining short duration across large parts of the fixed income universe and have tactically reduced our equity overweight. Yields are expected to move higher particularly in the US, where monetary policy is furthest removed from being accommodative. However, as output and employment gaps narrow in other regions as well, we expect yields globally to broadly follow suit.
More specifically, we made the following asset allocation changes this quarter:
- We reduced our equity exposure marginally and funded this adjustment by increasing our cash allocation.
- Within equities, we have reduced our exposure to more cyclical regions. The change is largely reflected through a neutral exposure to EM equities, having been our highest conviction overweight previously. Realised and expected tighter US liquidity conditions, alongside less favourable valuations and the prospect of less strong earnings growth make EM materially less attractive (Figure 4).
- At the same time, we have increased our exposure to UK equities from underweight to neutral and move to an overweight stance in US equities. The main motivation to take up UK equities lay in the broad-based valuation advantage, alongside improved future earnings prospects – helped by higher oil prices in the commodities sector and a fall in sterling.
- Within government bonds, we added US to our suite of short duration positions on the back of recent curve flattening and have reduced the short duration on core Eurozone bonds slightly.
- Our conviction in near-term Bank of Japan tightening has diminished; hence we have moved our maximum underweight position in Japanese bonds up a little.
- In terms of currencies, the portfolio has moved from being roughly neutral US dollar to slightly overweight. At the same time, we have positioned for a somewhat weaker euro, unchanged Japanese yen and a reduced degree of depreciation in the Australian dollar. As a result of a much less pronounced overweight in EM local currency debt and EM equities, our implied overweight in EM FX has diminshed.
- Our underweight in government bonds remains unchanged.
Global bond yields declined significantly in the wake of the Global Financial Crisis, helped significantly by ultra-low policy rates and unconventional monetary policy stimulus. As Central Banks reverse some of these measures, it should come as no surprise that volatility has picked up and that bond yields have come under some upward pressure. As our central economic scenario remains one of sustained, robust growth, with little prospect of recession in the next 12 months, we maintain our cautiously optimistic outlook and are positioned accordingly (Figure 5).
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