Volatility returns as markets change gears: A report from Portfolio Construction Forum Markets Summi
After an extended period of smooth sailing, volatility has returned to financial markets. Sovereign attended this years annual conference to learn from various market participants their broad views on the future;
Employment, wages, inflation and the future direction of interest rates dominated with two clear belief camps: Camp 1: Interest rates will rise by more than expected and there will be a market shock; Camp 2: Inflation will remain benign and the modest interest rate rises currently expected are fully priced in;
Sovereign’s view – we are cautious about the potential for interest rate rises to surprise and derail markets in 2018. This, however, is not our base expectation. We are therefore very selective about the type of fixed interest instruments we use. Similarly, we are conscious of the potential for an equity market shock and do expect more volatility than the last few years. We therefore prefer cautiously active management over index and exchange traded funds.
Investors’ time frames matter when making today’s investment decisions. Short term investors have a higher risk of disappointment.
Given the broad based improvement in economic data, long term investors need not be overly defensive this point in the cycle.
This Summit is run each year by Portfolio Construction Forum, looking at what has influenced markets over the previous year and, more importantly, on what is going to influence markets in the coming year and beyond.
The forum opened with commentary from esteemed organisations globally with positive but challenged outlooks. The International Monetary Fund (IMF) outlook “Brighter Prospects, Optimistic Markets, Challenges Ahead”, The World Bank global economic prospects “Broad-Based Upturn but for how long?” and the World Economic Forum Global Risks Report 2018 “acceleration in human interconnectedness is pushing……. communities and individuals to their limits”.
This year, the Summit inevitably focused on the future of inflation and interest rates and the implications for equity and bond markets.
Unsurprisingly, the professionals didn’t often agree. Will there be inflation? “yes, but not much”, “more than you expect and there will be an interest rate shock”, “don’t worry about it, it’s structural and short term”.
When the professional money managers don’t agree, the challenge is to make sense of their views. We can do this by going back to our investment philosophy, taking readings of valuation and momentum, review our investment time horizons and consider active versus passive management.
Some speakers did meet in the middle on two important considerations: how much an investor’s time horizon impacts the weight you put into short term (1-2 years) decision making; and what matters is not so much the direction of interest rates as the speed of change. To this end, if the near term blip in interest rates is regarded as a “bondcano” by the media, a large and fast rate rise may pose high short term risk.
We know the US has factored into expectations three rate rises in 2018. Domestically one rate rise is forecast. We also know that low interest rates have fuelled asset prices but, arguably, not unreasonably so given earnings growth has kept up (so far).
In this issue of the Sovereign News Feed, we have captured some of the views of each camp. The articles can be found here:
Look out – She’s gonna blow! (the higher inflation camp)
Relax! The sky isn’t going to fall (the lower inflation for longer camp)
If you are keen to read the reports of the IMF, World Bank and World Economic Forum, they can be found here:
World Bank – Global Economic Prospects
World Economic Forum – Global Risks Report 2018
So what did Sovereign take away from this day?
The world is doing pretty well. Company profits (earnings) are growing and support reasonable market valuations but we don’t expect to see the P/E expansion (equity prices rising without earnings growth) that we have seen over the last few years. Rather, earnings growth does justify current valuations but modest market returns are anticipated. Equity markets are susceptible to getting the jitters on concerns of an inflation surprise and a sharp increase in interest rates but this should not derail the long term investor. Equities are still expected to outperform bonds in the coming year and, indeed, over the next few years. International equities have greater earnings per share growth than domestic companies but we are cognisant of the benefits of franked dividends and how they enhance returns.
Whilst we agree that domestic inflation is benign, it is possible we could import inflation from overseas so we can’t ignore what happens in the US. Markets will watch leading indicators such as jobs data to extrapolate the likelihood and scale of wages growth and the impact this has on consumer behaviour, inflation and the likely movement of interest rates. I.e markets try to second guess the future.
At this stage of the cycle we are cautious about the type of bonds we hold for clients and how they are managed to deal with rising interest rates. We do believe they remain defensive in many downturn scenarios even though at times they may be correlated to equities. We do not yet see evidence that indicates inflation is likely to get out of control which could lead to an interest rate shock. We do see increased volatility given we are at a juncture where interest rates are turning. Investors will need to accept this and take the longer term view if they wish to earn returns in excess of inflation.
Talk to us more about your portfolio and what you need it to do for you.
Disclosure Statement: This communication has been approved and issued by Sovereign Wealth Partners Pty Ltd ABN 18 607 071 367 Corporate Authorised Representative (No. 001233909) of Bennelong Wealth Partners Pty Ltd ABN 44 164 127 833, AFSL 456235.
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