Market Comment 12/02/2018
A Bumpy Ride back to Earth
David Appleton, Investment Director at Cornelian Asset Managers, remains optimistic in the face of recent market volatility, which had caught many investors by surprise and explains why the spark that lit the touch paper was, ironically, a piece of good news!
The dramatic spike in market volatility in February caught many investors by surprise. Markets had entered 2018 full of optimism, with tailwinds from the synchronised upswing in the global economy that drove double-digit gains in equity markets last year expected to continue. Indeed, with the added impetus of US tax cuts and recovering commodity prices the support for global equities appeared, if anything, even stronger looking forward into 2018 and beyond. So why the sudden volte-face?
The spark that lit the torch paper was, ironically, a piece of good news. A US labour market update showed wage growth accelerating and more jobs being created than expected. This raised the spectre of rising inflation and pushed government bond yields up across the developed world. The scale, breadth and pace of the subsequent equity market sell-off suggests that investors were unprepared and unhedged against a return to more normal interest rates and monetary policy. This seems surprising given that this subject has dominated asset allocation debates in recent years and the changes to inflation and growth dynamics have, to date, only been marginally above trend.
Given that the fundamental backdrop is more favourable than at any time during the post-crisis era, commentators have rushed to find a bogeyman to blame. The spectacular collapse of some relatively minor esoteric products has created feverish speculation about whether the algorithms driving popular ‘risk-parity’ and ‘trend following’ strategies would automatically trigger further redemptions, leading to a self-reinforcing downward spiral.
This illustrates that the composition of the ‘market’ has changed dramatically in recent years, and how these changes impact market dynamics over time may be significant and is currently poorly understood. Volatility has morphed from being a statistical measure of financial stress to a key input in a wide range of investment strategies and products. The rising popularity of rules-based or factor-based investing creates additional complexity and risks of crowded positioning. At this juncture it is not at all clear whether the robots are to blame, or if this is simply a healthy correction. Investors have, in any event, been dealt a stark reminder that there are always two-way risks to asset prices after an unusually long period of almost uninterrupted gains.
Although this period of market turbulence has felt painful in the short term, this correction in our view could underpin healthier markets in the long run. We are excited about the opportunities facing our companies as they accelerate investments to grow and become more productive. While it would be unwise to attempt to call the bottom of this adjustment, we do not see broad-based evidence of universal overvaluation or of overly bullish expectations. Indeed, with improving growth momentum and still supportive credit conditions, this correction should help transition to a market driven more by fundamentals and less dependent on exceptional monetary stimulus. It may be a bumpy ride but based on the balance of evidence we see on the ground we remain optimistic on the outlook.