Why investors should be prepared for volatility

With a strong performance by the UK stock market over recent years, it has been reported that many investors have become overly optimistic about their expected returns. With forecasters suggesting that future returns will be below UK investors’ average expected returns of 8.7% over the next five years, there is a call for many investors to rebalance their expectations. As covered in our previous article, one of the ways to do this is to look at where we are in the current economic cycle and, as we highlight below, industry experts are gearing up for a period of volatility.

As global economic expansion enters its tenth year, there are signs that the market is entering the late stages of the current cycle. If the US economy continues to grow into the second quarter, it will equal and then exceed the second longest trough-peak expansion on record since the last one ended in 1969.

Late cycle booms also typically mark the beginning of the end, which suggests now is the time for investors to prepare for a potentially long period of more volatile and plateauing asset prices. Market prices have started to move to reflect our position in the cycle; US and emerging market equities have outperformed, the dollar has weakened, and the yen and emerging market currencies have strengthened.

Nevertheless, unlike previous cycles that came before a recession, we appear to be in a much healthier position – house prices have started to realign and do not look excessive, consumers have continued to spend due to low borrowing rates and the corporate sector has not over-invested in fixed capital. And despite recently higher equity market volatility and the US Federal Reserve continuing to raise rates, the ten-year yield remains below 3%, which is critical for the stability of US equity valuations. What’s more, with US inflation rates remaining in line with forecasts, the global expansion looks good to hold up for at least another year, maybe two.

However, with questions being raised over the longevity of the cycle, and the Nasdaq enduring its longest string of daily losses since November 2016, analysts are watching closely for signs that a recession could be on the horizon.

One of the reasons for elevated concerns over medium-term recession risk is that expansionary fiscal activity in the US has come at the wrong time; with the economy already operating at close to its potential, there is a risk of inflation overshoot. Increased inflation caused by fiscal stimulus could also encourage policymakers to push rates even higher. The ideal scenario here would be for businesses to step up investment in response to lower tax rates which, in turn, boosts productivity and potential growth output. Sadly, it doesn’t look like companies are willing to reply.

Talk of Trade Wars between the US and China have also been stealing the political limelight. Just as President Trump announced his plans to impose a 25% tariff on $60bn of Chinese goods, China hit back saying that if the US follows through, it would impose 25% tariffs on $50 billion of US shipments to the country. Whilst experts are viewing these actions as part of a wider bargaining strategy by the US administration, which will be settled with China in the coming weeks, it continues to add further uncertainty to an already nervous global market.

Should a recession occur, there are indications that it may not be very deep, due to the current lack of imbalances in the economy; however, it could be more prolonged than usual. The US economy appears to be in the driving seat, with the Fed already building reserves to cut rates and expand the balance sheet by the time the next recession hits. Worryingly, the European Central Bank and Bank of Japan do not appear to be following suit, leaving these two economies a little more exposed when the next downturn arrives.

Whilst nobody has a crystal ball to see into the future, at Finura we are keen to ensure that our clients have a well-informed and rounded view of what the next ten years will hold. Part of our strategy is to use multi-asset portfolios to help spread risk and help clients achieve their long-term goals. In our next article, we’ll be talking about diversification, taking a longer-term view on your investments and how volatility in the market can even create opportunities.

Capital at risk; the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Past performance is not a guide to future performance and may not be repeated.

Sources:
http://www.schroders.com/en/uk/tp/markets2/markets/why-we-are-shifting-gears-for-a-volatile-environment/
https://www.ftadviser.com/investments/2018/03/02/volatility-can-create-opportunities/
https://www.ft.com/content/05d2639e-414b-11e8-803a-295c97e6fd0b
https://www.bloomberg.com/view/articles/2018-03-20/el-erian-ten-things-investors-should-know-about-today-s-markets
http://www.schroders.com/en/uk/private-investor/insights/global-investor-study/uk-investors-expecting-returns-of-8.7-over-the-next-five-years/