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    Rothschild Private Wealth: Talking Point – February 2018

    09/02/2018

    Kevin Gardiner, Global Investment Strategist, Rothschild Wealth Management

    Market volatility: unsettling, but overdue

    The recent volatility looks likely to amount to the setback we have felt was overdue for a while now. We don't think this is the beginning of a stock market rout, or the end of this market cycle, however as investors we have to recognise that markets can be brutally unpredictable in the short term. Reassurances offered too easily can sound glib: accepting a degree of volatility is unavoidable at today's interest rates if we are to achieve long-term inflation-beating returns.

    The main US stock index has now fallen 10% from its January 26th peak, and the global market is down 9% in dollars. The UK stock market is down 8%. All three indices however are still registering positive year-on-year returns - the first two in double digits - a reminder that markets rose a lot beforehand

    Bond prices have also fallen, though less dramatically given their nature and potential safe-haven appeal. Inflation expectations have risen, but so too have real interest rates, and inflation linked bonds have also sold off. The dollar has (unsurprisingly in the circumstances) rallied.  

    What triggered the sell-off?

    As the week has progressed, three main drivers have become clearer. The initial sell-off was triggered by stronger US wage growth in January, which fostered fears that interest rates might rise faster and further than previously priced-in. The pattern of the sell-off, with many previous winners becoming losers, confirmed that profit-taking after the market's remarkable run was also playing a role. Thirdly, technical considerations - the collapse of short-volatility trading strategies, and the impact of algorithmic trading - have also played a role (as they did in 2010's “flash crash”). 

    Some context

    In our view, the rebound in US pay growth simply restores an upward trend that had faded, and reflects the stronger US economy - alongside added competition for capital - that the Fed has been anticipating. The Bank of England's comments yesterday on the possibility of an earlier hike in UK rates were also unsurprising (and in our view welcome). 

    Bond markets are at last registering a little more inflation risk, and nominal yields have risen above their recent trading ranges in the case of the US and core eurozone markets. Yields are nonetheless still at the lower end of their historic ranges

    There are few signs of US or global growth faltering - nor reasons to expect it to do so yet. Corporate profits are sharing in that growth, with the prospect of lower US business taxes still not fully reflected in analysts' expectations. Globally, growth looks both healthy and relatively evenly-distributed, with few signs of excess. In particular, there is little sign of reckless borrowing: US consumers are still net savers in the ninth year of an economic expansion.

    Inflation and interest rate risk is indeed increasing (and in this context, those US tax cuts were not so helpful). It is doing so from very low levels, and gradually, but faster than markets have been pricing in. It is possible that the Federal Reserve may now be tempted to go slower again because markets are volatile, but we think this could be counter-productive and would not be surprised if US rates were to rise again in March (or in May here in the UK).

    US equity markets had their strongest January (+5.7%) since 2010, when the market was still recovering from the GFC.  It has still been over two years since we have had a 10% pull-back in equity markets and the low volatility that persisted for most of last year was unlikely to last forever. Valuations are at above-trend levels, but not alarmingly so - particularly given the trend in corporate profits (which in the US may be extended beyond its usual cyclical extent by those tax cuts).

    Gold is often vulnerable to rising real interest rates and we do not advocate it as a safe haven here. Cryptocurrencies are not safe havens, and in our view do not belong in long-term wealth-preserving portfolios.

    No change in our view

    Some protection has been warranted, but from a macro perspective we still think that a more substantial portfolio restructuring would risk leaving us stranded if markets rally. Stocks are the most volatile asset class, and markets can be brutal: it would be foolhardy to suggest that we have necessarily seen the worst. But we see them eventually stabilising and delivering inflation-beating longer-term returns. Bonds are much less volatile, but may not revisit their peaks, and seem likely to underperform inflation. 

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