The LGIM Asset Allocation Team believes it is important to be calm and to understand the seriousness of the situation. Market moves since the start of the year have certainly highlighted the risks of investing in equities, but they believe that this is an environment with opportunities for medium-term investors. Emiel van den Heiligenberg, Head of Asset Allocation at LGIM, comments.
“Markets started the year in turmoil, and with the exception of a few moments of relief, have remained tumultuous. What’s different in February is that the focus has switched from China, commodities and emerging markets to developed markets – particularly cyclical equity market sectors and banks (both equity and credit).
“The MSCI World equity index is down around 20% since the 2015 highs. This kind of sell-off is what people usually identify as an equity bear market. We have also seen credit spreads on corporate bonds start to rise and expectations for interest rate hikes in the UK and the US pushed back substantially. In fact, there is now a decent chance of an interest rate cut from the Bank of England priced into markets. Have markets lost their heads, or is something serious unfolding?
Are we facing a recession?
“Markets are worrying about recession and the tightening in financial conditions raises the risk that this could be self-fulfilling. In this turmoil, it is important to realise that economic cycles usually do not die of old age and only some of the typical late cycle features are currently present. Recessions typically require a combination of excess demand, domestic imbalances, interest rate increases and large external shocks. The external shock which is currently playing out in the markets is that of weak emerging markets growth and rising credit risks, especially in the energy markets.
“So while a number of emerging market economies are under significant pressure, we remain relatively constructive on developed market growth. US household real incomes remain strong, supported by lower energy prices and decent employment growth. The key trigger for recession would be if the corporate sector decided to retrench, making labour market indicators an important area of focus.
What can we expect from interest rates?
“Negative interest rates have become a fact of life in the euro zone and (more recently) Japan. In the absence of a major downturn, we do not anticipate rate cuts in the UK, and so expect some retracement of yields after the recent sharp fall. However, we are not expecting a major reversal given the significant pressure of low inflation and negative interest rates in other parts of the world economy.
What’s happening with equities?
“Equities are pricing a material risk of recession. However, we see a developed economy recession as an alternative scenario than our base case. Equity market stress has been compounded by renewed questions about the ability of central banks to stabilise confidence. This dynamic has been most acute in Japan where recent monetary policy easing has been met by a stronger currency and weaker equities: exactly the opposite of the intended impact.
“We agree with the argument that monetary policymakers are constrained. However, it is a mistake to think that policy is impotent. The last few years should have taught us that policymakers will continue to innovate with ‘unconventional tools’ in their efforts to support growth and inflation.
In conclusion
“Recent financial market developments are definitely concerning, especially as they bear some of the hallmarks of the previous financial crisis. The last few weeks have certainly highlighted the risks of investing in equities. But it is also after such episodes that the potential rewards are greatest. With that in mind, we are looking for buying opportunities amid the market turmoil. Leaning against the weakness, rather than capitulating into it, is likely to be rewarded in the long run.
“We believe this is an environment rich in potential opportunities for a medium-term investor, but also with a number of risks. This is not or not yet the time for heroic calls that we have reached the low point for equities or bond yields. Moreover, we firmly believe thatour funds should remain diversified. In recent weeks we have gradually reduced duration exposure. As rate cuts are pushed further back, and recession risks priced in, the upside to bonds is reduced in our view.
“With regards to equity exposure, we remain tactically positive on equities and where fund risk appetite allows it we generally want to buy into further equity weakness. While we can’t identify the catalyst that will turn equity markets around, history tells us that whensentiment is clearly negative a little good news can go a long way. Where possible we have used options to mitigate downside risks. We have also selectively reduced risk exposures that have not experienced any notable weakness, but could if some of the tail risks materialise. In this light emerging market local debt exposure has been removed or reduced in applicable portfolios.”
|
