How volatility and cheap money are enveloping investment markets
2016 has been fraught with short, sharp bouts of market volatility. A large number of these episodes have been driven by the prospect of the US Federal Reserve (Fed) raising rates, indicating that asset prices appear to be primarily driven by availability of cheap money rather than underlying fundamentals. Continued easy monetary policy from central banks has seen markets steadily rise over recent years amidst historically low volatility. And as seen just three months ago with Brexit, markets are seemingly choosing to turn a blind eye to the risks in the world, of which easy monetary policy is ironically a symptom – the cash rate is not low because things are in good shape.
September has brought with it yet another spike in market volatility
Markets were sold off heavily in light of speculation of an increase to the US federal funds rate after a highly anticipated speech given by Fed Chair Janet Yellen to central bankers in late August. She stated that “the continued solid performance of the labour market and our outlook for economic activity and inflation” has “strengthened” the case1.
However, none of this is new information. The Fed has long been flagging further increases and while the market has been sceptical of the pace of such increases, it has been factoring in the probability of a rate rise towards the end of 2016 for some time. And despite no increase yet, futures markets continue to factor a 68 per cent2 chance of an increase at the Fed’s December meeting.
The lead-up to this meeting could again prompt volatility as investors focus more on the uncertainty of a decision rather than the actual decision itself. Despite this potential, we continue to believe that rising US interest rates are positive for a number of reasons: they show a rebounding economy, limit distortion on asset prices from ultra-low rates, and decrease the interest rate differential with Australia, placing downward pressure on the Australian dollar.
Cheap money availability has effectively brought forward investment returns from future years
In what is truly unprecedented territory; compressed yields are such that over US$13 trillion3 of government bonds are now trading on a negative yield. The investment landscape is making it increasingly challenging to obtain appropriate reward for additional risk as low interest rates force the hands of investors into higher risk asset classes such as equities in order to generate a required level of return.
We urge caution for investing in the current environment. While the most likely scenario is that the global economy will continue to muddle along as central banks attempt to kick-start inflation, recent events demonstrated how susceptible the market is to a broad-based sell-off in the event of a significant catalyst. Uncertainty surrounding the November US election gives further reason for investors to be skittish.
One development we continue to watch closely is the unfolding situation of Deutsche Bank
News of the US Department of Justice seeking a US$14 billion fine4 relating to the sale of mortgage-backed securities prior to the global financial crisis has raised serious questions as to the solvency of Deutsche Bank (central to Germany’s banking system and Europe’s fourth largest bank by assets).
Further complicating the situation is the tense political environment in Europe. Germany seemingly cannot afford to let Deutsche Bank falter, but at the same time it would appear politically unpalatable to provide a European Central Bank funded bailout having previously been vocal in the refusal to allow the same for Italian and Spanish banks. Any escalation in the matter has the potential to reignite issues in Europe, which could well spark contagion across global markets.
Sharp equity market movements are a timely reminder to be conscious of potential market risks
It's important for investors to avoid becoming complacent despite central bank monetary policy suppressing volatility. In light of these ongoing developments, our preference is to invest in real assets such as property and infrastructure. In equity markets, we prefer regions such as Asia and emerging economies that are trading on historically cheap valuations compared to their more expensive developed market counterparts. Amidst the backdrop of heightened geopolitical risks, we find the lofty valuations of a number of the more developed equity market regions difficult to justify, increasing the downside risk in the event of a global sell-off.
This insight contains general financial advice and was prepared without taking into account your objectives, financial situation or needs. Any forward looking statements in this insight are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct. As always, your personal circumstances are critical when considering any financial strategy and seeking professional personal advice is highly recommended.