Europe  

Summer calm to autumn storm

Summer calm to autumn storm

Three months on from the EU referendum and, so far, it can be said that Brexit-inspired volatility was short lived and has given way to extreme calm. Indeed, the VIX index – a key measure of market expectations of near-term volatility – has recently dipped below 12.

If that is not enough to sound alarm bells, analysis of historic data suggests a summer calm is usually followed by autumn frenzy – with October the usual annual peak (see bar chart). Looking ahead, therefore, it will be key to consider asset allocation and diversification more closely with a view to managing this volatility and capitalising on shifting market dynamics.

Given the tendency for volatility to rise at this time of year, and with no shortage of potential catalysts, some managers have decided to be a little more cautious in their asset allocation than would otherwise have been the case. 

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First on the list is a possible Fed rate hike: recent data seems once again to have pushed back that possibility, but any hint of a Fed hike could cause market unease. I would actually be quite relaxed under such a scenario, as the history of Fed hikes suggests equity-like assets tend to do well when the Fed is raising rates.

More of a concern would be a weakening of US and/or Chinese economic data. The thing most feared is recession (volatility is usually higher and risk assets do poorly).

The oil price also has the power to destabilise markets: it is currently trapped between the hope of Opec/Russian production restraint and the reality of record output and stubbornly high inventories. I still think oil will bottom at $20. Markets still behave as though that would be a problem.

Two obvious political catalysts could be the Italian constitutional referendum and US presidential elections. A defeat for the Italian government in that referendum could in theory lead to the resignation of the prime minister and perhaps elections. Any sign of the anti-EU Five Star Movement getting close to power could be destabilising.

US presidential elections are not usually market moving events, but the “maverick” nature of Donald Trump makes this episode harder to read. Hillary Clinton built a solid opinion poll lead after the party conventions, but that is being whittled away.

Expected total returns (annualised, local currency) and Source Multi-Asset Portfolio*
 Expected Total ReturnsNeutral PortfolioPolicy RangeSource Multi-Asset Portfolio*Position vs. Neutral
 1-year5-year    
Cash & Gold-7.90%-3.30%5%0-10%10%Overweight
       Cash0.10%0.60%2.50%0-10%10%Overweight
       Gold-15.90%-7.20%2.50%0-10%0%Underweight
Government Bonds-0.70%-0.70%30%10-50%23%Underweight
Corporate IG-1.00%1.30%10%0-20%10%Neutral
Corporate HY-2.30%3.30%5%0-10%3%Underweight
Equities3.50%6.80%45%20-70%50%Overweight
Real Estate5.20%5.50%3%0-6%4%Overweight
Commodities-39.90%-3.10%2%0-4%0%Underweight
*This is a simulated portfolio. Source: Source Research 

What does all this mean in terms of asset allocation and diversification?

The sharp drop in yields reduces the potential for return, especially given a lingering fear that oil will drop to $20. Real estate remains a favourite, but after a three-month gain of 6.8 per cent (globally, in USD), Source decided to scale back the extent of the Overweight. The position is therefore cut from 6 per cent to 4 per cent (versus a Neutral 3 per cent), with the cuts focused on the Eurozone and EM.

The proceeds from these portfolio adjustments can be allocated to a combination of government bonds and equities.