February offered investors a glimpse of what could happen if economic conditions and policy shift slightly on their respective axes. While our returns were not spectacular in February, they were positive against a backdrop of some large falls in equities (while global equities declined around 3.5% during the month, intra-month declines in some markets were in the order of -10%) and wider credit spreads, mainly in the high-yield space. This served as a timely reminder that risk does matter, and certainly from our perspective in managing the strategy, avoiding/mitigating drawdowns is an extremely important objective. While we acknowledge that our returns would have been better in 2017 if we’d held more equities, this is a double-edged sword. More equities are fine on the way up, but punitive on the way down, and, while we’d like to think we can time markets, the reality is we can’t. February showed what can happen.
Despite a frenetic start to 2018, much of the trajectory of markets is as expected and forecasts are unchanged for the medium term. However, with indicators that core inflation is rising — particularly in the key US market — it remains to be seen how policymakers will deal with this issue, and also how it will affect investor perceptions about the prices they pay for assets.
Separately, the sovereign bond markets have had a shaky start to 2018 and while we’ll hold back on saying there’s a start of a bear market on bonds, there are two ways it could go — to blow out, or blow up. A blow out would come as gains accrue in the absence of a market shock, like inflation. A blow up could occur with anything that challenges the fundamental macro and policy support for the market, including a growth shock from China, a pick up in wages or inflation, or central banks being slow to respond to inflation.
The near euphoric sentiment evident in January was a good precursor to February’s re-pricing. The bigger risks though are fundamental, and rising inflation is a legitimate cause for caution.
Read full insights here
What a difference a day makes! Early February was marked by a significant change in sentiment with equities falling sharply, credit spreads widening and volatility (remember that) rising sharply to levels last seen in 2015. The positioning that had dampened returns in January, helped offset the volatility in early February. That said, February is still young, so more about this next month.
With global markets experiencing significant turbulence — and the Dow Jones Industrial Average experiencing its largest one-day drop since December 2008 — Schroders’ head of fixed income & multi-asset, Simon Doyle, explains five key points to know about what’s unfolding at the moment.
1) It’s not unusual
While we have seen some large falls in global share markets over the past two days, these falls are not unusual in the context of market corrections. What has been unusual has been the historically low volatility seen over the last couple of years. The recent fall has only taken most markets back to levels seen in the second half of 2017 — and in some cases earlier this year.
2) It’s not a surprise
We have been of the view for some time that there was a significant and growing mismatch between potential downside risk due to valuations and volatility, and are accordingly defensively positioned. Relatively extended valuations in key equity markets — especially the US — and very narrow credit spreads made the market vulnerable to any news that derailed the strong growth, low inflation, accommodative policy backdrop embedded in pricing.
3) Inflation remains a key issue
The key challenge to this thinking has been inflation, with strong global demand (helped along by the US tax cuts) and growing evidence in both the hard and soft inflation and wage data (especially in the US) of a more pervasive rise in inflation, challenging current policy settings and relatively benign central bank rhetoric. Rising inflation and rising yields changes the relative pricing of assets classes, making bonds more attractive compared to equities, but also makes it more difficult for central banks to maintain what are still unusual levels of policy accommodation.
4) Bonds reclaim some ground, for now
Bonds have retraced some of the recent sell-off amid a “flight to safety”, and some investors are questioning the potential for the Fed to tighten if markets are unravelling, but we do not think the bond rally will extend given the challenge posed by rising inflation risks.
5) It was possible to prepare for this
While we do not know how long this volatility/correction in risk assets will last, we are relatively well positioned having increased defensive positioning in light of demanding valuations and growing confidence in our thinking about rising inflation.
Where opportunities will lie for tactical diversification
In the Schroder Real Return Strategy (SRRF) we have maintained relatively modest equity exposure, including virtually no exposure to US equities; elevated cash levels and a focus on high quality, investment grade credit. We have also been building inflation protection into the portfolio via cash, inflation break-evens, positioning directly away from bond “proxy” assets like REIT’s and shortening duration. We are not rushing to re-enter markets (given the correction is only a few days long) but anticipate that this will at some point provide an opportunity to add some risk, tactically, back to the portfolio. In the Schroder Balanced Fund we are underweight equities, underweight A-REITs and overweight cash. Finally, in the Schroder Fixed Income Fund (SFIF) we are neutral credit (having cut credit exposure last week), and have been increasing our structural short duration positioning. Similar to Real Return, we anticipate this volatility and risk repricing to provide us with a tactical opportunity to add credit risk back to the portfolio.
2017 was noted for its lack of volatility, and this can be seen strongly in the performance of global equity markets. For the first time, global equities (based on the MSCI ACWI’s 30 year history) saw a rise in every month of the year. The US market (S&P 500), while not posting a rise every month, saw a positive return every month once dividends are included, the first time since 1958. The largest fall for the US market intra year was 3%, which is the smallest intra year fall in any calendar year in the post war period.
Another area of note were signs of , most notably with the interest in cryptocurrencies. Bitcoin saw a rise of 1,300% and created billionaires of the Winklevoss twins, who were previously known for claiming Mark Zuckerberg stole their idea for Facebook. It was also reflected in the art world, with a world record $US450m paid for Leonardo Da Vinci’s Salvator Mundi, shattering previous records – over double the previous record for a painting sold at auction and a third higher than the highest private sale.
So after a record breaking year, it is worthwhile reflecting on what lessons we can learn from last year.