Thoughts from the Investment Desk
In our view, the origin of this correction was the turn in the US dollar last year which loosened monetary conditions in the US. This, combined with an improvement in wage growth, resulted initially in a sell-off in bonds as market participants priced in a more proactive Federal Reserve.
In our view, the origin of this correction was the turn in the US dollar last year which loosened monetary conditions in the US. This, combined with an improvement in wage growth, resulted initially in a sell-off in bonds as market participants priced in a more proactive Federal Reserve. Indeed the correction so far in bonds has reflected a reassessment of Fed rate hikes rather than a move in the term premium. As US bond yields approached 3%, this raised concerns about the valuations in equities.
What has exacerbated the market weakness has been the rise in the VIX Index which forced leveraged short volatility strategies to close their positions.
We do not think it is useful to try and predict the impact of systematic de-risking as different strategies such as CTAs and volatility hedging have different triggers. Rather, we prefer to focus on fundamentals. So far bonds have sold off together with equities but, based on our analysis they are now starting to offer value and we believe that further significant falls in equity prices would prompt a safe haven bid for bonds as investors would worry about the impact of market volatility on growth. As a consequence, having reduced our duration sensitivity over the past several months due to our concerns about the diversification benefits of bonds, we dipped our toe back in this morning by buying US 10 year bonds. We also continue to own risk reducing positions in the Japanese yen against the euro, a short position in Italian bonds and TIPS. We believe that although correlations may be elevated, there will be benefits to diversification.
From an equity standpoint, we are maintaining our exposure. We have been positioned for an environment of improving growth and gently rising inflation. Our cyclical indicators point to a continuation of this environment. We also continue to favour emerging market currencies against the US dollar as we see valuations as being constructive. Interestingly, a number of emerging economies are benefitting from ongoing trade surpluses confirming that the rebound in emerging market currencies so far has not been excessive.
So all in all, we have added to our defensive positions by buying back a small amount of duration. We are maintaining our reflationary positions in equities and currency. Here is a summary of the key indicators we are watching:
- US treasury yields – a move beyond 3.25% on the US 10 year against a backdrop of falling equity prices would be troubling from a correlation perspective
- US yield curve – a flattening yield curve would suggest that long term growth assumptions are being questioned
- US dollar – our central scenario is for the US dollar to remain on a weakening trend. We prefer hedging risk through long Japanese yen positions. A significantly stronger US dollar would tighten global liquidity and threaten our emerging market exposures.
- A move to the “Slowdown” phase on our cyclical indicators would trigger a significant defensive shift (right now we are still in “Recovery”/”Expansion.”
With regard to the volatility markets, we would expect implied volatility to remain elevated relative to last year due to the exit of short volatility participants from the market. However we would regard this as a move to more normal and sustainable levels of implied volatility particularly against the backdrop of quantitative tightening. We have been running at lower risk levels than normal for the last couple of years reflecting our view that it was imprudent to extrapolate suppressed levels of volatility into the future so this shift does not require a change in the way we manage our portfolios.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.