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Riding the volatility wave

In his latest quarterly review and outlook, David Riley gives his thoughts on global growth prospects, the rise in market volatility, favoured asset classes and what investors should watch out for going forward.

Does the rise in market volatility in the first quarter signal the beginning of the end of the current economic cycle?

Investors are more nervous about the outlook for global growth and recent data for developed economies, especially Europe, has been softer than market expectations. But we believe it marks a pause rather than inflection point for global growth.

The synchronised global economic upturn remains in place. Global aggregate demand is strong, order books are full and rising capacity utilisation is driving a pick-up in global capex. Fiscal stimulus has yet to feed through to stronger growth in the US and China and emerging markets seem to continue to grow at a steady pace.

In our view, the recent volatility, especially in US equity markets, primarily reflects stretched valuations and market positioning as well as noise around trade protectionism rather than signalling a slowdown in growth and corporate earnings. It is noteworthy that owning traditional fixed-income – highly rated government bonds – has provided limited diversification benefits during the recent episodes of equity market drawdowns.

It comes as no surprise, therefore, that in the in the transition to the post-QE world, investors are increasingly seeking alternative fixed income investment strategies that have the potential to exploit higher market volatility and dispersion in asset performance while provide some diversification benefits.

What are our broad asset views as we enter the second quarter of 2018?

As we enter the second quarter, most of BlueBay’s investment strategies are to varying degrees overweight credit risk and neutral interest rate risk (duration).

Going into this year, short positions on US interest rates were a strategic feature of several strategies. But as the market converged with our own views for three 25bps Fed hikes this year and at least two for 2019, we decided to close our positions and realised gains. We believe that global rates markets are more or less fairly priced at the moment, although of course that can change and we are always prudently on the look out for market dislocations.

In credit, we continue to favour emerging market over developed market credit and European over US credit. Emerging market economic and credit fundamentals are improving and valuations are more attractive than in developed markets. In our opinion, emerging market local currency debt looks especially attractive due to improving external finances, relatively high nominal and real interest rates, and currencies that are fair-to-cheap. In our multi-asset credit strategies, we have added to our emerging market local currency exposure funded by reducing our developed market high yield holdings.

Technical headwinds are playing a major role, where the rising cost of FX-hedging is eroding international investor demand for US fixed-income and credit while supply remains very strong. European credit is low yielding but the supply and demand dynamics are more favourable and monetary policy remains very supportive.

European bank healing and strengthening credit fundamentals remains a key investment theme and is reflected in an overweight in bank debt (particularly lower down the capital structure) across several strategies including our multi-asset credit.

So we think that investors should remain ‘risk-on’, but what are the downside risks?

We think the single biggest risk is that trade tensions between the US and China escalates and cuts short the synchronised global economic upturn. The Trump administration’s ultimate goal is to negotiate changes in trade arrangements that open up rather than close down opportunities for US businesses. The US recently agreed a free trade deal with South Korea and progress is being made on re-negotiating NAFTA with Canada and Mexico after US sabre-rattling. It is an aggressive and far from diplomatic approach to international trade relations, but we are confident that Washington and Beijing will avoid a ‘trade war’. The other threat to risk assets is that US inflation picks-up more quickly than expected on the back of fiscal stimulus and the Fed meaningfully accelerating the path of interest rate hikes.

However, in our view, these downside tail-risks are now better priced in markets than at the start of the year. Global growth is stabilising at a high level rather than on a downward path and corporate earnings continue to rise strongly. Ultimately, healthy fundamentals support positive performance for growth-sensitive risk assets.

But in a more volatile environment, we believe investors should avoid being whipsawed by markets overshooting between greed and fear. Now more than ever, investors should focus on the basics of investment – fundamentals; valuation; diversification and risk management – and try best avoid the false security of passive benchmark strategies.