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Volatility Update

World markets have now entered an official bear market using the most common definition of being more than 20% down from their peak.

Whilst the press will have a field day with this, we do believe the worst is now behind us. We have said many times that 10%+ falls in markets happen pretty much every year, whilst 20%+ drops happen around every 4.8 years on average. Therefore, a fall of such magnitude was only a matter of time and perhaps was long overdue!

We still believe the market falls are largely due to a perfect storm of commodity shock, exacerbated by slowing growth and currency fluctuations partly driven by central bank policy. That is now having a knock on effect on the shares of certain banks but we think fears of another meltdown are totally misplaced.

Portfolios have generally held up relatively well but we recognise that any losses are painful. However, we certainly don’t think now is a time to panic and jump ship, in fact we think now might be a good buying opportunity.

To that end we’ve been buying equities at this relative low in most portfolios.

 

Adapting to Market Conditions

Last week I wrote a blog explaining that we had decided to sell some equities as the FTSE recovered above 6,000. You can read this blog by clicking here.

In essence, in the blog we acknowledged that the economic outlook had worsened and we felt this was therefore likely to supress equity returns compared to what seemed likely a few months ago.

Previously, we had wanted to be marginally “overweight” equity when markets were at 6,000, meaning having slightly more equity than usual in portfolios. However, given our change in view we sold down one of our volatility trades at just above 6,000 and moved back to a “neutral” position – in line with our long term positioning.

The main reasoning was to reduce risk as we felt the chance of the market dropping further had increased. Unfortunately, this fear has been proven correct and as I write the market has dropped below 5,550 (morning of 11 February).

The other reason for selling equity at 6,000 was so that we could take advantage of further falls by buying in at a lower point. We had felt that anything below 5,600 was a good entry point and we have today instructed the purchase of a new “volatility trade” for clients on the Nucleus platform. This should go through tomorrow.

For clients who have investments on the 7IM platform where trading processes differ, we bought a couple of days ago at around the 5,600 level.

Whilst we have revised down our outlook for equities, at this level markets are starting to look pretty attractive using the valuation metrics we consider important.

 

The Banking Sector

One of the reasons for the renewed fear in markets is to do with the banks. Their shares have dropped markedly, notably the shares of big European banks, Deutsche Bank and Societe Generale. Bonds issued by certain banks have also been hit.

This is partly because banks are sensitive to the economy and if the outlook worsens the chance of people or companies (especially commodity related companies) defaulting on loans increases. However, it is also more difficult for banks to make money in the current financial environment.

Banks make their money by lending over the long term at high rates, and borrowing money over the short term at low rates. The difference between long term and short term rates is as low as it has been for several years.

This is exacerbated by central banks moving to negative interest rates, including the European Central Bank, Bank of Japan, and the Swedish and Swiss central banks. Meanwhile, the chance of further rate increases in the US has receded, and there is even speculation that the Bank of England may consider CUTTING rates rather than putting them up. This all makes it a difficult environment for banks.

To be clear, the chance of a major bank going bust or defaulting in a major way is very low in our view. Banks have much bigger capital buffers than they had in 2008, for example, and have undergone regular stress tests by regulators. However, investors are concerned that they are under stress and as a result may suspend dividend payments, or even interest payments on certain bonds.

It will be interesting to see what central banks do next as it is monetary policy that is a large driver of markets at present. It is their conflicting policies that are contributing to volatility. However, this does give opportunities to certain funds especially in the “alternative equity” sector.

As a result, we have just reduced property exposure for most portfolios and are increasing allocation to the alternative equity part of portfolios. Property has had a great run and has carried on making money whilst stockmarkets have fallen. We think now’s a good time to take some profits by reducing the property weighting by a few percent and use this to take advantage of the opportunities that we expect the current volatility to provide.

 

P.S. After criticising the press for their negativity, I have just come across this article from Ambrose Evans-Pritchard at the Telegraph. It is well worth a read as it gives a much more balanced view than many of his colleagues in the press! http://www.telegraph.co.uk/finance/economics/12150909/This-is-a-global-stock-market-rout-worth-celebrating.html


The content contained in this blog represents the opinions of Equilibrium investment management team. The commentary in this blog in no way constitutes a solicitation of investment advice. It should not be relied upon in making investment decisions and is intended solely for the entertainment of the reader.