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.
Looking forward, we can think of several events that could be catalysts for a spike in volatility, both economic and political.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 Returns | Neutral Portfolio | Policy Range | Source Multi-Asset Portfolio* | Position vs. Neutral | ||
| 1-year | 5-year | |||||
| Cash & Gold | -7.90% | -3.30% | 5% | 0-10% | 10% | Overweight |
| Cash | 0.10% | 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 |
| Equities | 3.50% | 6.80% | 45% | 20-70% | 50% | Overweight |
| Real Estate | 5.20% | 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.
On the basis of a global economy continuing to muddle through, we at Source still believe the best medium-term returns will be earned on equity-like assets. If we are wrong, and the global economy is heading for recession, there would be few places to hide (gold and quality sovereign debt, for example).
| Expected total returns (annualised, local currency) and Source Multi-Asset Portfolio* | ||||||
| Expected Total Returns | Neutral Portfolio | Policy Range | Source Multi-Asset Portfolio* | Position vs. Neutral | ||
| 1-year | 5-year | |||||
| Cash & Gold | -7.90% | -3.30% | 5% | 0-10% | 10% | Overweight |
| Cash | 0.10% | 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 |
| Equities | 3.50% | 6.80% | 45% | 20-70% | 50% | Overweight |
| Real Estate | 5.20% | 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 | ||||||
The global economy appears to be still growing at about 3 per cent per year. Despite obvious concerns about certain economies, this has been enough to propel equity-like assets higher over the past six months, without pushing central banks to tighten. In some ways it may be the ideal (Goldilocks) scenario.
We suspect other Bric economies have passed the weakest point of their cycles and changes in consensus forecasts for 2016 GDP growth suggest we are not alone. The same applies to Australia, for which growth forecasts have recently been upgraded.
However, there has been a clear deceleration in major economies. Brexit concerns do make many cautious on the UK economy, while US data is not very convincing at this stage. The Fed is struggling to follow up on last December’s inaugural rate hike and the Bank of Japan, European Central Bank and Bank of England have eased further during the course of this year, with a mixture of rate cuts and more generous asset purchase programmes.
Unfortunately, these central bank policies have not gained traction, neither in terms of boosting economic activity nor raising inflation. Perhaps the central banks are fighting the wrong battle. Market data suggests inflation is governed in some way by demographics. If so, that is unfortunate because it suggests inflation will remain subdued over the coming decades, no matter what the central banks do.
Lower demographic growth will inevitably be associated with lower economic growth, so we may have to get used to a lower growth/lower inflation environment.
That suggests interest rates will remain lower for much longer than is generally appreciated – demographic trends are expected to remain subdued throughout the rest of the century.
Fortunately, there is little relationship between inflation and equity market returns, so we do not have to get too depressed.
Paul Jackson is head of research at Source
Key points
Three months on from the EU referendum and, so far, it can be said that Brexit-inspired volatility was short lived.
Two obvious political catalysts could be the Italian constitutional referendum and US presidential elections.
There has been a clear deceleration in major economies.
