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Article | 06 June 2018 | Investments
Although some economic indicators have eased off slightly from very positive levels, the outlook for global growth remains strong.
This year we have been saying that market volatility is set to return to normal levels. That mantra is still in place, especially in the light of recent political developments.
Last week saw an increase in volatility. Following an inconclusive Italian general election in March, the two Eurosceptic parties trying to form a coalition were stymied by Sergio Mattarella, the current president. Mattarella blocked their preferred choice of Finance Minister, Paolo Savona, and subsequent attempts to form a ‘technocrat’ government also failed. This turmoil spooked the markets as investors feared any new vote could turn into a referendum to leave the euro.
The Italian micro drama led to a couple of days of heightened volatility. On Wednesday the market was pricing in the worst-case outcomes, but by Thursday things had settled down as investors realised that those worst-case outcomes were in fact fairly unlikely. Italian bonds rebounded strongly, and this was vindicated when a new coalition government was eventually agreed later in the week.
The Italy drama was another in a series of episodes of volatility this year. In the past few years, with a synchronised global economic growth recovery in place, at least partly engineered by central banks’ easy liquidity conditions, volatility reached record low levels. As a result, investors had begun to become complacent about risks and were happy to keep buying.
What we have seen this year is a return to fairly normal market reactions with investor sentiment swaying as news flow is received and digested. Previously, negative reactions to adverse news flow were muted by the overarching positive sentiment. Now we are seeing what we would normally expect when negative news breaks: a kneejerk initial reaction followed by the realisation that things aren’t so bad, bringing with it a rebound as investors return to the market. We saw this with the trade war scare, North Korea, and most recently Italy.
This reintroduction of volatility into markets can be self-fulfilling. As volatility rises investors get more skittish, and can exacerbate the moves as they get nervous and sell when markets decline, and buy back when markets recover. Other investors may try to take advantage of volatility, believing that they can sell at the top and buy at the bottom. This is a difficult skill, and those that get it wrong can end up having to chase prices as they scramble to close their positions.
Volatility is usually triggered by a surprise, and by definition, surprises are difficult to forecast. The next catalyst could come out of anywhere. At the beginning of the year, few people were suggesting that a trade war would spark an equity sell-off. Likewise, North Korea wasn’t really on the radar as a source of risk - nor indeed as having the potential to be the positive catalyst it became when relations with the US briefly thawed!
But even though surprises are hard to predict, it’s important to remain vigilant, to consider potential sources of risk. Our process tries to identify the biggest areas of concern, and at the moment, we are monitoring the following:
China: the perennial risk of an economic hard landing
Liquidity: some fixed income markets could suffer if liquidity dries up
Trump: erratic policy decisions
Brexit: still a long way to go; all outcomes still technically possible
Sterling: currency strength could pose a threat for UK investors
US dollar: further dollar strength could be a risk to global growth
Oil: this has the capacity to affect inflation, either positively or negatively, with knock-on impacts on interest rates
At the moment we are reasonably sanguine on most of the potential risks highlighted above. Although some economic indicators have eased off slightly from very positive levels, the outlook for global growth remains strong. Our positioning is slightly ‘risk on’ as we focus on the long term and avoid overreacting to volatility. That’s not to say we ignore it, rather we try to avoid reacting to price moves that might be exaggerated and don’t reflect what has actually changed fundamentally.
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This is for financial adviser use only and should not be distributed to, or relied upon by, retail clients.
The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. Past performance is not a guide to future performance. The views expressed within this article are those of Architas, who may or may not have acted upon them.