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Key Themes – October

The barbecue summer has given way to the first chill breeze of autumn. A reminder that the seasons change. However, whereas we can predict with a certain amount of accuracy the coming of winter, economic and market forecasting is an altogether more uncertain affair.

October can be a notoriously volatile month for financial markets and so it has proved this year. The origins of turbulence witnessed at the beginning of October lie in the issues that have confronted investors for some time now: trade war tensions, Brexit uncertainties, rising interest rates and the general withdrawal of liquidity from financial markets. All legitimate concerns but hardly new.

The catalyst for the recent volatility appears to have been the US employment report highlighting that unemployment in the United States has fallen to its lowest level in fifty years. So good news. However, the announcement raised the spectre of rising interest rates and with Fed Chairman Jerome Powell determined to continue on the path to “normalise” monetary policy, there was a fear that interest rates might continue to rise even as economic growth began to slow down. As expected the US President had a public view on matters tweeting that the Fed ‘is making a mistake’ and ‘has gone crazy’.

All that was needed then was for the hedge funds’ algorithm driven programme trades to kick in and the bandwagon started to roll. But while such volatility is unsettling it can throw up opportunities. Whenever there are conflicting signals it pays to refocus on the fundamentals.

• The global economy, and America in particular, continue to grow strongly, albeit at a slower rate.

• Inflation is present, but subdued.

• The US China trade war, whilst an unwelcome distraction, is expected to have a limited effect on world trade. What’s more, we are approaching the point where the tensions are beginning to be felt by the parties involved and with Presidents Trump and Xi due to meet in November some resolution may be reached, especially if a compromise can be agreed which allows each side in the dispute to present themselves as a victor.

• Interest rates, though rising, are doing so gradually and in response to sustainable economic growth and while America’s Federal Reserve remains resolute in its determination to push rates higher it does not want to choke off growth prematurely. They are giving clear signals about their intentions.

We are not complacent and understand perfectly how some clients feel unhappy when markets become more volatile than they are used to. It may surprise many that a 5% reduction has been a regular occurrence. In fact this is the 23rd time it has happened in the S&P 500 since the bull market began in 2009. Previous drops in markets have been long forgotten particularly for those with medium to long term investment goals.

Elsewhere in the world monetary policy remains accommodative with the European Central Bank not looking to raise rates until the second half of next year, the Bank of England likely to keep rates on hold until at least the summer of 2019 and Japan unlikely to raise rates in the foreseeable future.

In terms of strategy, our manager partners remain constructive on equities though are in some cases adopting a more conservative approach. While rejecting media speculation of a possible recession, some are taking steps to adjust exposures where risks associated with a maturing economic cycle have increased. For example, reducing exposure to higher yielding corporate debt markets and allowing cash levels to increase slightly. These moves take a little risk off the table.

In the US, the windfall effect of last year’s tax cuts is expected to moderate over time and as higher interest rates feed through we may see other global markets catch up as we see some rotation out of US equities into those developed markets with a more attractive valuation base i.e. the UK, Europe and Japan.

We are beginning to see tentative signs of a change in ‘style bias’. This is evidenced by the move away from growth stocks to those with value characteristics. It is too early to say whether this trend shift will be sustained but it is a reminder that, for active managers, volatility presents opportunity. It is also a reminder that having a mix of styles, assets and geographic exposures within an investment proposition is necessary when the winds blow in a different direction.

Nowhere is this more apparent than in Emerging Markets which divide our manager partners. They all concede that after the fall this year EM assets are on much more attractive valuations than their developed market counterparts and potentially represent a good long term buying opportunity. Historically, though, emerging markets have struggled against a headwind of rising US interest rates and some of our managers are preferring to keep their powder dry hoping for a lower entry point at which to build up holdings.

UK and European markets, again, are viewed as fundamentally undervalued, particularly the UK given its international complexion and weak currency. However, the fog of Brexit hangs low over both markets and our managers are perhaps understandably reluctant to take speculative views. The situation remains fluid and binding agreements uncertain. The main aspect for investors is what will happen to sterling once the outcome is known. Thankfully, all our managers have capabilities to manage currency exposures and they do so to varying degrees.

Amidst all the uncertainty, more clearly indicated is the likely path of interest rates and the effect on bond markets. With the yield on the US 10-year Treasury now over 3% and offering a real return, after inflation, managers are becoming more positive on US bond markets, looking to move duration out slightly and consider more extended maturities.

Looking ahead, volatility may well prove to be the order of the day for some time to come as monetary policy tightens and financial markets acclimatise to a less accommodative environment. That said, while markets fluctuate, for multi asset investors there is always an opportunity blowing in on the winds of change.