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Market forces

The extreme conditions have tested the strategies of absolute return fund managers to the limit

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Absolute return funds aim to provide investors with positive returns in all market conditions. However, the unusual circumstances of the past several years have presented portfolio managers with an unpredictable environment in which to develop strategies to maximise performance.

One reason for this is that Government bond markets are being influenced by opposing forces. On the one hand, lacklustre economic growth and subdued inflation enables Governments to maintain interest rates at low levels while institutional demand helps to keep yield levels low.

At the same time, central banks are having to issue large volumes of bonds to fund Government activities but have recently sought to put quantitative easing on hold, so removing an important buyer from the market.

Such tensions have seen yields trade in ranges in recent months but have also made yield movements more unpredictable.

Another more recent variable has been a rise in concerns over Greece’s ability to service its high debt level. Worries over sovereign risk have spread to other highly indebted peripheral European economies, such as Portugal and Spain, as well as the UK.

However, unlike the other troubled eurozone economies, the UK retains its own currency and still has the added policy tool of devaluing its currency.

This leads us to the significance of developments in currency markets. At the turn of the year, the dollar was seen as a high-risk currency and, accordingly, it was weak on the foreign exchange markets. Although the dollar remains weak against a number of emerging market and commodity currencies, we have lately seen a turn against the euro and sterling, which today are viewed as the higher-risk currencies. With the US likely to lead the developed world in the economic recovery, we believe the dollar could remain strong against the euro and the pound in the short term.

With short-dated bond portfolios producing lower returns, it is important to maintain a highly liquid and flexible approach with a focus on capital protection

Meanwhile, investors have begun to pay attention to political news as there has been much press speculation about the possibility of a hung Parliament in the forthcoming UK general election, although we believe this risk is overstated and think it most likely the Conservatives will win the election with a good working majority. Any result that reduces policy uncertainty would be taken well by the gilt market and sterling.Therefore, after the election we see the potential for a rally in both markets.

How does one manage a portfolio to maximise results against such a backdrop? Though markets have recently been range-bound, intraday
volatility remains a feature.

Meanwhile, the suspension of quantitative easing in the UK, the end of mortgage buybacks in the US, patchy economic data and heightened sovereign risk are all likely to lead to high levels of volatility in coming months.

We expect interest rates will remain low for longer than the market is discounting.

In this environment, and with short-dated bond portfolios producing lower returns, it is important to maintain a highly liquid and flexible approach with a focus on capital preservation. There should be good opportunities via both long and short positions in bonds and currencies. Identifying
opportunities to add incremental value and having the discipline to lock in gains promptly are, in our view, equally important.

It is unlikely that any clear market trends will emerge until the second half of the year at the earliest and, as such, a short-term trading approach is appropriate.

David Carr is an investment specialist at Threadneedle

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