What, in your opinion, caused recent market movements?
In the last few days, we have seen a sudden change in market sentiment that has affected all main asset classes. Volatility is back, with the VIX index close to 30, a level not seen since the middle of the Euro crisis. As often happens, during phases of market turmoil, risk assets suffer across the board and show high correlation in the short term. The S&P is down more than 8% since its September high and the same weak trend can be seen in Asia and in Europe, where the Eurostoxx 600 is down more than 10%.
In contrast, we have seen a “flight to quality” effect on core government bonds (10 Year Treasury and Bund yields, respectively close to psychological threshold of 2% and 0.75%) and gold.
The main reasons behind the recent market movement include increasing concerns regarding slowing growth and deflation risks facing the global economy, and in particular Europe’s economy. These renewed fears have put into question the investment thesis that many believe had prevailed for the last few years.
- The global economy could progress slowly at a sub-par, but positive pace;
- Central Banks would intervene in any case, not only to suppress volatility, but also to support market levels during the most critical periods.
Risk management activities, such as stop loss on the US yield curve have amplified the market movement.
What are the main economic factors to consider?
Going forward, we believe there are two main and strictly connected factors to consider.
The first is that weaker economic conditions, especially in Europe but also in Emerging Markets, may drive a global slowdown, as the US alone is not able to drive the world economy.
The second is that, at this stage, the Central Banks are running out of weapons to combat the economic slowdown. After 5 years of extra loose measures, the incremental benefit of further actions is seen as marginal, especially in the U.S. Markets are also becoming more and more nervous on the effective will of the ECB to intervene with unconventional measures to support an anemic Euroland economy .
What is, in your view, the main scenario for the coming months?
The economic scenario is uneven in different areas and becoming more fragile. We believe that the key area to watch is Europe, where the risk of deflation is on the rise and economic growth is very weak. The loss of momentum in the German economy could put further pressure on a more accommodative monetary and fiscal policy (such as the implementation of a broad public investments plan, as recently advocated by the IMF). A weaker Europe could also impact the U.S. economy. Here the outlook is more benign, with decent growth and an improving labor market, although recent data (retail sales) has been weaker than expected. With a longer term perspective, the key element to watch is capital expenditure, which is still the missing element in this recovery.
Emerging economies are also slowing down. They still retain a positive growth differential with developed economies but they are facing a structural transformation of their economic models that we believe will likely imply slower growth going forward.
Overall, we assert there are also rising risks to the main scenario related to geopolitical tensions (in Ukraine and the Middle East), possible mistakes in monetary and fiscal policies, and concerns about Ebola, which could have a negative impact on confidence in the last part of the year.
What are, in your view, the implications for investments?
For the reasons above, we see in front of us a period of market uncertainty. Over the summer, as the bull market was becoming mature, we had already taken a more cautious approach in our allocation, by taking profit on credit markets.
We have maintained a constructive view on equities so far, as we expected more Central Banks actions (especially in Europe and Japan), structural reforms to proceed (see for example the labor market reform in Italy) and a more pragmatic approach of European authorities to avoid a further deterioration.
At the same time, we have also sought to build some protection in our asset allocation, for example, by hedging the main risks to our scenario (geopolitical risks and deflation in Europe). This decision has helped to mitigate the effects of volatility in the current market conditions.
We believe that going forward the focus on risk management and broad diversification will remain key. We have been very disciplined in implementing our drawdown management principles, such as stop loss discipline (in Fixed Income) to help protect our clients investments as much as possible.
We are aware that investing today is not an easy task. Investors should consider that the returns from all asset classes in the next few years could be lower than in the past and the economic environment is particularly complex.
In the short term, we believe that the current phase of volatility is going to last until we see a decisive change in the policy mix that has prevailed so far and that has proved to be ineffective to lift the rate of growth of the global economy.
Therefore, we better fasten our seatbelts!
Giordano Lombardo is group CIO at Pioneer Investments