What does August’s volatility really mean for investors?
It’s likely not escaped your attention that the past few weeks have seen increased volatility and sell-offs across global markets. Emerging markets bore the brunt initially, as growing concerns over the economic slowdown in China put a downward pressure on commodity markets and emerging market currencies. Developed markets then subsequently followed suit, with European and Japanese equities falling over 15% from their levels in mid-August (the Russell 1000 index has been more resilient, off ‘only’ 6.3% as at August 21st, but is playing catch-up as bad news travels west).
So what’s causing this?
We believe that investor concern about China has been a key driver of recent volatility from markets selling-off. It has been apparent that the Chinese economy is going through a difficult adjustment period as it transitions from a global manufacturing powerhouse to a consumer-led growth model. This does not happen overnight, but recent turbulence in the China A share market, a modest devaluation of the Renminbi exchange rate and disappointing data on exports and industrial activity, have all raised concerns that a ‘hard landing’ is underway.
What is Russell’s perspective?
In Russell’s third quarter Global Market Outlook, our Strategist Team highlighted that market volatility was likely to pick up as we moved closer to the first rate hike from the U.S. Federal Reserve. The team expressed a neutral view on equities versus fixed income, noted that the U.S. and European economies are in recovery mode, and that their resilience is expected to drive a sustained period of modest global growth. These views have not changed and we are analysing the current market situation to assess potential return opportunities and appropriate risk management strategies.
Observations from around the globe
China and Emerging markets
We are likely to see continued pockets of turbulence in China, its Asian trading partners and commodity prices, and we remain cautious on these markets in the near-term given the macro headwinds. While downside risks have clearly escalated, we do not expect an uncontrolled deceleration of the Chinese economy. With over $3 trillion in reserves, the Chinese government has both the ability and willingness to cushion the economy and recent high frequency indicators on housing prices and retail sales have shown tentative signs of stabilisation.
In the United States, the disinflationary impacts from declining commodity prices complicate the Federal Reserve’s decision to hike interest rates. We still expect Fed ‘lift-off’ in September, but it is now a very close call (roughly 55% probability in our view). Importantly, that lift-off decision would be predicated on improving U.S. economic conditions. Employment growth remains robust and the broader economy has reaccelerated after a slow start to 2015. We continue to expect healthy U.S. real GDP growth of 2.5 – 3% over the next twelve months which should help push the global economy forward.
European financial markets have faced significant downward pressure in recent weeks. However, the domestic Eurozone economy continues to improve and the tailwinds from a lower exchange rate, cheaper oil prices, aggressive monetary policy, and attractive relative valuations underpin our continued expectation of strong performance for the region over the next twelve months. We are closely monitoring the situation for potential opportunities given the region’s strong fundamentals.
Lower oil prices continue to boost earnings expectations in Japan. Meanwhile, the labour market is very strong and there are some tentative signs that wage growth might pick up. Less positively, growth in Q2 disappointed, driven by a weak Japanese consumer, and Abe’s reform agenda appears to be stalling. On balance, we remain constructive on the market, but are keeping a close eye on the business cycle for any signs of deterioration.
How are we positioned in response to this?
In equities, our exposure to more defensive/quality-oriented managers, and the continued underweight to the Energy sector, has helped relative returns in the global space. In Europe, our strategic preference for mid- and smaller-cap companies has been positive as larger cap companies have sold off more aggressively, while in emerging markets underweighting the large Asian markets has been helpful.
In fixed income, while we continue to expect interest rates to rise, our funds are less underweight duration than they have been for some time. We are also tactically underweight emerging market debt in our multi-asset credit portfolios. Both positions have benefited relative performance in recent weeks.
In our multi-asset portfolios, equity weightings are at the lowest level they have been since the Global Financial Crisis and cash has reached circa 10% in absolute return mandates such as MAGS. We sold commodities and US small cap equity earlier in the year, moved to a short position in emerging markets equities, trimmed high yield credit and recently bought into European and US government bonds. These moves reduced our exposure to risky assets, which is positive, but with meaningful weightings in equities, the sell-off represents a significant headwind.
So what’s next?
Sell-offs of this magnitude can solicit a variety of responses, from panic to euphoria, depending on your perspective. In order to maintain a level head at such times it is important to adhere to a disciplined investment process and not run for cover at the first sign of turbulence. As always, Russell’s investment teams in London and across the world will closely monitor and appraise market conditions as they unfold.