Managing expectations

Managing expectations

While life on Mars is under investigation by the Curiosity rover, down here, investors are being forced to contend with volatility once again as markets are hitting low after low.

Does this backdrop signal the onset of a long-term bear market or, more optimistically, are we simply waiting for lift-off? The performance of equity markets has rarely been this challenging in January. While China kicked off the downtrend, declining oil prices, geopolitical tensions between Iran and Saudi Arabia, and a disappointing earnings season could continue to cast a shadow that keeps the equity market firmly out of bull territory.

Where should investors turn? Global convertible bonds belong to the risky asset-class group, but their asymmetric return profile may prove interesting in 2016. The market has been trending downwards in the first weeks of 2016, but volatility rather than an overall downwards trajectory may ultimately be the dominant feature of the Year of the Monkey; or will it be the year of the central banks? Either way, convertible bonds offer the potential to partially protect on the downside should the trend build up for a more bearish turn, and to capture positive returns should markets recover.

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There are a number of potential sources of volatility in 2016: ongoing Chinese headwinds; more hikes from the US Federal Reserve (but maybe fewer than expected); geopolitical risk, with tensions in the Middle East already escalating between Iran and Saudi Arabia, and the Syrian crisis continuing; the euro, where risks exist but, for now, the European Central Bank (ECB) is keeping the currency weaker and buying politicians time to enact reforms; Brexit, though at this point in time a UK exit from the European Union remains a headline risk; and the US economy, with downside risks to growth in this presidential election year.

Since the Fed began to stop quantitative easing in late 2014, bursts of volatility have become more frequent and certainly more violent. Volatility spiked, for instance, in August and December 2015 and, during these phases, global convertible bonds offered relative protection in an almost automated manner.

The year ahead will no doubt be a complex one to navigate but it is still too early to assert that we are entering a long bear market. Concerns remain over China’s growth rate while oil price movements are under constant scrutiny for positive signs. Will global growth stutter in 2016? Investors would do well to look beyond the current turmoil and take a cautious but positive stance given the potential for pockets of growth in developed markets and more domestically focused equities or convertible bonds.

Worse-than-expected December retail sales in the US were reported recently, weighing on market sentiment and altering the market’s view about the future path of Fed rate hikes. What about the ECB? President Mario Draghi confirmed the willingness and determination of the ECB to achieve its objective. Meanwhile, the ECB will assess their stance at its next Monetary Policy Committee meeting in early March. With Germany’s ZEW economic sentiment indicator falling from 16.1 to 10.2 on 19 January and the recent market turmoil, further easing cannot be ruled out. But growth will be a key element of the equation too.