A wake-up call for markets. Remain vigilant
The volatility spike in February is, in our view, a clear wake-up call for investors, and the market correction has partly removed the complacency that characterised financial markets in the last few months. While technical factors (position unwinding of specialised short volatility funds) are the main cause of it, we should not underestimate other factors that deserve attention, and which will potentially will write a new story for financial markets.
The financial cycle is becoming increasingly mature after an extended bull market for risk assets; a repricing of inflation expectations is under way (some signs of wage inflation are finally materialising in the US in an economy running at full employment and fueled by robust fiscal stimulus). While Central Banks (CB) will clearly remain vigilant in order to assess any financial stability risks, a removal of excess monetary accommodation, with different speeds among various CB, is expected to continue, with a progressive tightening of financial conditions, potentially leading to higher market volatility. The recent market correction is, in our view, unrelated to recession concerns: the economic outlook still supports earnings per share growth, and some positive conditions, such as a capex revival and increased global trade, could drive an extension of the business cycle. However, we do not yet see this as an entry point: we believe it is too early to seize opportunities since the correction has been limited and incomplete (not affecting the credit market), and it is too early to tell if we are seeing a regime shift in fundamentals (ie, structurally higher inflation). Moreover, valuations are still high, less than one month ago, but still high, especially in credit market. They remain vulnerable to any pick-up in inflation data, which should drive a further rapid re-pricing of CB action. We have seen that markets may have limited capacity to absorb higher rates. In our view, a 3% yield for the 10-year US Treasury is a warning level, and 3.5% is clearly an alert threshold. If reached too fast, this is unlikely to be sustained without a second wave of market correction, which cannot be ruled out, in our view. Higher interest rates would have an impact on asset class valuations, putting pressure on some indebted corporates, on equity earnings, and on EM assets, should they aggressively and rapidly rise. Market liquidity, in this regard, will be a critical factor to watch. As such, the wake-up call should be taken as an opportunity to reassess the robustness of a portfolio entering into a new regime, where volatility will not be extreme, but higher than the depressed levels reached in 2017, and rates will continue to trend higher. Under this scenario, as we highlighted in our 2018 outlook, we believe investors will be exposed to asymmetric gain/loss distribution. To deal with this challenge, we think it is time to both recalibrate risks and implement investment strategies that can benefit from the last phase of the financial cycle (to enhance gain potential) while protecting assets from downside risks (to mitigate losses). In details, we see five appropriate investment strategies. First, on a cross-asset basis, while keeping moderate risk-on positioning to exploit the opportunities of the last phase of the cycle, we believe that equities should remain favoured over credit (high yield in particular). Second, in the equity space, further selection is needed in favouring the markets that offer higher return potential (Europe or Japan, and selective EM), and/or which, through an active approach, can still post value in some sectors/stocks (US). The third theme is related to the recalibration of monetary policy and inflation expectations’ repricing, and their impact on fixed income. These trends call for a flexible and more diversified approach to bonds (duration, curve, currencies, credit exposure, inflation linked, floating rates, and convertibles). The fourth is related to the resilience of EM assets. Even if not immune to rising rates, stronger economic conditions, and the adjustment in major imbalances, a weak US dollar should mean more robustness regarding the effects of higher interest rates than in the past. Lastly and even more importantly, in our view, as highlighted by the recent market correction (equity sell off and rising bond yields at the same time), is the implementation of effective hedging strategies that can help to mitigate the downside if the correction were to continue.