Fixed Income  

Adaptability is key to emerging from volatility gloom

This article is part of
Investing in Fixed Income - November 2015

Concern over the outlook for global growth, particularly in China and other emerging markets, has been unnerving investors of late. Moreover, the prospect of the US raising its interest rate against this backdrop has merely added to this anxiety.

Many financial assets have suffered as a result, making it harder for fund managers to generate returns. Stocks in the US and UK have only recently managed to eke out positive returns year to date after a tumultuous summer.

The Chicago Board Options Exchange’s Volatility Index – also known as the ‘fear gauge’ – surged by almost 120 per cent during one week in August, the largest weekly jump since the index was introduced in 1993.

Meanwhile, emerging market equities remain in negative territory, and emerging market currencies’ brief bounce in October unwound after the US Federal Reserve sent fresh signals that an interest rate increase could occur as early as its December policy meeting.

The central bank’s latest statement indicates that policymakers have been less concerned in recent weeks about turbulent financial markets and uncertain economic developments overseas.

Expectations for a December rate rise based on federal funds pricing have since snapped back to a 50 per cent probability.

The US dollar’s advance against emerging market currencies has been further supported by hints from the European Central Bank (ECB) that it would extend both the duration and perhaps the scope of its quantitative easing programme beyond the targeted end date of September 2016.

The prospect of another cut in the deposit rate was also raised, in spite of the ECB’s earlier pledge that rates had reached the lower bound.

Investors are currently grappling with the prospect of higher borrowing costs in the US, easier monetary policy in Europe and decelerating growth in China – the world’s second largest economy.

But for investors prepared to see through the short-term volatility, the excess of gloom may be misplaced.

Signals from the Chinese government suggest Beijing could tolerate growth as low as 6.5 per cent, marking a shift to a slower pace.

However, the purchasing managers’ index for China pointed to a broad stabilisation of business activity in October. Activity in the services sector rose at a quicker rate, expanding at its fastest pace in three months, suggesting the country’s previous stimulus efforts may be starting to take effect.

Policymakers have demonstrated they stand ready to respond if China’s slowdown accelerates.

Elsewhere, clear signs of economic recovery in the eurozone continue to emerge and we expect this trend to continue, supported by the ECB.

The lagged effects of weaker oil and commodities prices should also act as an additional fillip to growth.

Once the moves in energy prices drop out of the annual comparison, we would expect inflation to edge higher. Longer term, the central bank’s stimulus efforts should push inflation back to target levels.

Investors should recognise that not all volatility is bad, especially for portfolio managers that have a flexible approach that allows them to add value and express their investment views precisely.