Category Archives: Simon Doyle

Blow-out, or blow-up: Why risk still matters

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.

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Caution remains warranted

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.

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Five things you need to know about the current market turbulence

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.

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Growth, inflation and central bank cocktails

November was on balance another good month for risk assets reflecting an ongoing cocktail of reasonable growth, low(ish) inflation and gun shy central banks. Equity markets gained (with the exception of the UK and Europe) and credit spreads retraced some of their recent modest widening. Also helping performance was a rally in Australian bonds (as the RBA showed little sign of raising rates), a weaker AUD and a rally in GBP as the UK moved closer to an agreement on Brexit.

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Lessons learnt since 1987

The first is that this job is hard. While it’s easy to look back and identify what you should have done, it’s much harder to make decisions in real time, looking forward into a future that is in large part unknowable. While technology means we can now process more data better and faster (and as a result have better back tests) it doesn’t change the fact that the future is inherently difficult to predict. Being wise in hindsight is popular but unhelpful.
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