As summer draws to a close, markets are entering what is historically a more difficult period for returns. Over the past few months, markets have drifted higher, boosted by strong earnings data and supportive economic headlines offsetting building political risks, principally concerning North Korea.
Investor sentiment remains positive, and the economic backdrop remains robust, but there are certainly risks to financial markets resulting from a shift in tone from the central banks.
It is tough to gauge the extent to which markets have been driven higher by the policies of the central banks over the past decade, but trillions of dollars of ‘freshly printed’ money have flowed into financial assets. If we are to see a change in the direction of that flow over the next six months, this might begin to have an impact.
September has the potential to deliver more volatility from politics – the German elections were not a significant risk, but there is plenty to concern us in the US given the elevated political noise surrounding the Trump administration.
The country’s debt ceiling issues have been kicked down the road to December thanks to Donald Trump doing a deal with the Democrats, to the annoyance of his Republican party. In the short term, it is positive that a government shutdown and a potential technical default has been avoided, even if only for a few months. We have seen plenty of noise over raising the debt ceiling in the past few years, not least thanks to the increasing polarisation of US politics.
Geopolitics and the building crisis over North Korean missile tests and nuclear proliferation has the potential to have a big impact on risk appetite. The risks to markets are building, but with benign economic data and the central banks for the moment remaining broadly dovish, there is scope for equities to make progress.
Bond markets are sending a cautious message, with concerns over political risks along with slowing inflation, pushing yields lower. Often I am asked what the catalyst will be for a change in the market mood. It is not easy to pick a single event that will turn the tide, but there are plenty of risks from geopolitics and central banks’ language and actions.
That said, anyone who waits for a catalyst will likely not spot it until it has happened.
What we do know is many of the positive tailwinds for markets – such as cheap borrowing, plentiful dividends and share buybacks – are a direct result of extremely low interest rates.
Any change in this backdrop will have consequences.
The US Federal Reserve is likely to indicate a tightening in policy (albeit not a rate rise) this month, while we need to wait until at least October to hear more from the ECB on potential QE tapering, which will have the potential to test market sentiment.
I continue to take comfort from the economic data, but feel a lot of the good news is already in the price. Equity and bond markets, neither of which can be described as cheap, are vulnerable to a building set of risks.
The party might not be over yet, but the longer it goes on, the worse the hangover. In our portfolios at BMO Global Asset Management, we have taken a little risk off the table and reduced our equity exposure, adding to funds with an absolute return philosophy such as Majedie Tortoise.
Anthony Willis is an investment manager in the multi-manager team at BMO Global Asset Management
