Q: Actually, has this really been a risk sell-off?
A: Emerging market equity has held up well, as have Emerging Market currencies. Investment grade bonds have continued to experience inflows. Spreads on Italian and Spanish government bonds have widened versus German bunds but haven’t moved a huge degree in absolute terms (Italian 10yr started the quarter at 2.844% and is now 2.829%, as of 11 August). It would be wrong to think of this as a return to the risk on/risk off world of 2008-2013. Generally, those areas that were over-owned have experienced the worst of the correction.
Q: So what will happen next?
A: We believe that the recent correction is primarily a market readjustment driven by repositioning and the usual lower volumes during summertime. We don’t think that we have seen the equity peak for this cycle, even though we expect higher volatility and lower yearly equity market returns than we have seen in the past few years. In our view, valuations are not over-extended, particularly outside of the US, and relative to other asset classes offers more value. In particular, the recovery in the US economy should sustain global growth and allow for higher sales numbers in the coming quarters which will compensate for either higher wage growth (in the US) or modest economic growth numbers (in Europe).
Q: Do we have any worries?
A: Yes, we are always retesting our investment views! While we still think the valuation case for European over US equities is very supportive, we are re-examining the macro and earning gaps, particularly in light of the Russian sanctions and growth data in the Eurozone. We are also looking at global saving/borrowing imbalances as we think this is a meaningful longer-term risk for the global economy. Finally, we are also concerned that, as the US economy strengthens ahead of the rest of the world, changes to Fed policy could be inappropriate for certain European and Asian economies still dependent on US monetary policy. In this regard we hope that the Fed has learnt its lessons from the correction of spring 2013. All of this leads us to expect a world of higher volatility for risk assets in the foreseeable future.
Q: What about geo-political risks?
A: While many of the geo-political events of the last few months have led to significant human misery, in terms of macro-economics or earnings the effects have been rather limited. The possible exception to this may be the Russian sanction on EU food imports. While Russia had already been on a path of limiting European food imports for some time (for example, all EU pork was already banned in Russia due to an outbreak of African Swine Fever in the Baltic states), the latest sanctions increase the breadth. Our initial assessment is that the consequences will mainly affect citizens of Russia’s larger cities, who will be confronted with higher food prices, leading to a 1 to 2 percentage point rise in inflation rates down the line. This could become quite an issue for the Russian Central Bank which was already forced to raise its leading interest rate to slow down capital outflows and the weakening of the ruble. Of course, any ban on flights using Russian air space would clearly have more significant earnings and potential macro implications.
Q: Are there upside risks?
A: Yes. If the European economy continues to disappoint the ECB might take firmer steps towards unconventional measures and possibly asset purchases but this is unlikely to happen in the next few months and the Comprehensive Assessment remains the ECB’s focus for 2014. We could increasingly have to deal with a situation comparable to the one we have had in the US over the last few years: every time the economic landscape deteriorates, the ECB will be tempted to come back with new measures which, in turn, will be positive for risky assets. Furthermore, we shouldn’t forget that outside of the weaker Eurozone data, the global recovery has gained further traction with signs of acceleration in the US and stabilization in China.
Q: What is Global Investment Solutions doing with our multi-asset portfolios?
A: In GIS, we identified the risk in high yields early and took portfolio action. At this stage we feel that is too late in the correction to sell further equities and we are looking to the following signposts to potentially add an overweight in client portfolios:
- A reduction in geo-political tension between Russia and the EU (and to a lesser extent the US)
- Positive price momentum or at least stabilization, indicating that the positioning rotation has played out
- Supportive policy action, especially from the ECB
