A period of transition

The early weeks of 2018 were full of twists for financial markets, with a rapid rise in bond yields leading to a short, sharp sell-off in equities. And while volatility subsequently fell back, it has still not returned to the low levels of 2017.

What is going on? According to Christophe Donay, Head of Asset Allocation & Macro Research at Pictet Wealth Management (PWM), the correction we saw in early February was “the most visible sign yet of a shift to a new economic policy and market regime”.

The previous regime was marked by low growth, low inflation and low interest rates as central banks adopted increasingly accommodative policies, according to Donay, whereas the era we are entering is characterised by higher growth, higher inflation and higher interest rates. “Transitions from one regime to another are rarely smooth or without incident”, writes Donay, and so it is proving to be. While fundamentals for risk assets remain sound, “the need for markets to adjust to a new regime could lead to further volatility in the weeks ahead,” he believes.

Cesar Perez Ruiz, PWM’s Chief Investment Officer, strikes an equally prudent note, The dynamics between growth, earnings multiples and inflation are relatively ‘standard’ concerns but will need to be monitored very closely in the months ahead, but to them now must be added potentially negative developments in international trade. And yet, like Donay, Perez Ruiz remains comfortable with his positive stance on equities. “As long as inflation remains under control and growth continues, high multiples can remain intact,” he writes.

But after a 10-year-old bull market, had investors become complacent before the early-year sell-off? After all, writes James Ind, PMW’s head of Multi-Asset Flexible Strategies, the period since the end of the financial crisis “was one of the least volatile and most profitable…since time began”. With the progress of markets seemingly inexorable and volatility low, selling volatility products or options “were money-making machines, feeding on the payments of the cautious”.

But now investors have to be aware of striking a balance between being too complacent and too cautious. There are plenty of risks out there. Even a “rather boring and traditional” economic cycle has the potential to push profits back to their long-term levels and to compress valuations. “It wouldn’t be hard for that to translate into a 50% fall in stocks”, states Ind.

But such risks are still worth taking, as well as they are well understood. That leaves the “unknown unknowns”, the unforeseeable. Ind believes that portfolios need to be hedged against such risks under certain conditions. “if the market is prepared to sell you risk against the unforeseeable on the very cheap, it is always worth considering… The end of 2017 was such a time,” writes Ind, but reminds investors that “there remain traditional portfolio hedges that retain their value or moderately improve in their own right during normal periods.”