It would seem some volatility is returning to risk assets as geopolitical concerns continue to dampen sentiment and improving economic data leads investors to fear interest rate rises. The summer months can often be difficult for risk assets; volumes tend to be low and market moves can be exacerbated. We should remember rising rates thanks to an improving economy are no bad thing, particularly if inflation remains benign. In this environment, equities can still make reasonable progress.
The risk-reward from fixed income, however, looks much less attractive and fund flows data already suggests money is starting to flow out of some fixed income assets, particularly high-yield bonds. If this stream becomes a flood, market liquidity issues could become a problem once again.
Fixed income markets have grown massively on a wave of quantitative easing money since 2009 but, thanks to investment banks pulling back from fixed income trading, the market has little depth and is extremely opaque. This is fine in a rising market as companies have issued plenty of cheap debt to income hungry investors. However, if there is a rush for the exit, liquidity could dry up very quickly. This is something at the front of the mind of every bond manager we speak to.
We are concerned over a further escalation in the two current main geopolitical risks – Ukraine and Israel/Gaza. Although this is often the case, it is the unknown or unexpected event which will cause the market to sell off. What is positive is we are in the midst of what seems to be a good corporate earnings season and the economic data remains generally supportive. The market levels certainly already express this positive view and therefore we are not looking to add to risk assets at this point.
We now know US quantitative easing will end in October. The end of QE has tended to be associated with a pick-up in volatility and while we will have to see if history will repeat itself this year, we expect the US economic data to continue to pick up, which may offset the end of QE to an extent. For some other parts of the globe, the era of central bank support and loose monetary policy is a long way from ending, with QE still taking place in Japan, and the European Central Bank may yet be pushed to take further action.
Overall, our economic outlook remains broadly positive. The US is growing, China appears to be benefiting from mini-stimulus which is now feeding through into stronger growth, the UK is doing very well and Asia should benefit from a pick-up in China. Japanese data of late has disappointed but we still expect progress.
Europe, however, remains an issue from an economic point of view and still has not reached “escape velocity”, that is, growth on a sustainable positive path. While the economic picture overall is reasonably good, the outlook for markets remains less clear. We have not seen a 10 per cent correction in the US since August 2011 and with heightened fears over rate rises and the end of QE coming ever closer, the coming months will most likely see further volatility across equities and fixed income as investors.
Rob Burdett is co-head of multi-manager at F&C Investments