Who kidnapped Goldilocks?

investment strategy

Goldilocks was known for her finicky tastes in porridge... and equities

By

David Clark, Director
Paul Ashworth, Managing Partner


Posted 09 February 18

The recent equity market gyrations over the last 10 days heralds the end to Goldilocks equity volatility, of which the hallmark has been overly-benign volatility for the last five years.

Goldilocks Has Left the Building

The recent equity market gyrations over the last 10 days heralds the end to Goldilocks equity volatility, of which the hallmark has been overly-benign volatility for the last five years. This market volatility has not been driven by weak company wide fundamentals or economic weakness. In fact, we are currently experiencing a US equity reporting season which has delivered robust earnings results and generally significant increases in dividends. That said, it would be naive to simply dismiss this extreme market volatility on short-term market factors.

Our core Cameron Harrison Economically Responsible Asset Allocation Strategy has been in a highly conservative setting for some time due to our assessment that markets had been poorly valuing forward risks. Markets overshoot and significantly undershoot; both scenarios afford good opportunities for disciplined, rule-based investors. Effective long-term investment management is ultimately about the transfer of wealth from the impatient to the patient.

Comment #1 – US Equity Markets Led

The recent step-up in market volatility has been driven by the US equity market and for which world equity markets have suitably followed. The Australian equity market looks to be fairly valued. We would, however, note that the Australian market is overly exposed to bank financials which have a set of forward risks to the downside combined with weaker China demand not leading the world economy.

The extent of movement in US equity volatility should however not be simply ‘brushed aside’. As can be seen in the below graph, the jump in volatility has been extraordinary over the last week which should be mirrored against the unrealistically benign volatility of the last few years. Some volatility is desirable in order that investors can factor it into proper, reasonably based investment decisions.

For over 25 years we have consistently reiterated that we do not purchase the market but rather, individually well-conducted firms whose forward prospects are fairly valued. Significant downward volatility affords the opportunity to do this.

One Week Change in S&P500 and VIX Index

Diagram showing One Week Change in S&P500 and VIX Index

Comment #2 – Bond Markets to Central Banks: “You’re Behind the Curve”

Bond markets (longer end rates) have been shifting up their assessment for future interest rates largely on the back of higher inflation and increased US government funding requirements. Similarly, short end money markets have shifted their assessment for the path of the Fed Funds Rate (the cash rate) over the last four months. Previously, October 2017 market forecasts (aqua line) were well under the Federal Reserve member forecasts, and now they are categorically telling the Federal Reserve to start increasing the Fed Funds Rate post haste (orange line).

This week also coincides with this being the first week for new Federal Reserve Chairman, Jerome Powell. Like Greenspan in 1987, he inherits the US and world economy doing very well, but with asset markets having risen rapidly aided by the Fed’s policy of highly accommodative monetary policy. Combined with very recent Bank of England Governor Carney indicating that UK cash rates may have to rise faster than previously indicated, further underscores that heightened volatility will be present for some time to come.

Fed Funds Target, Markets and FOMC Forecasts

Diagram showing Fed Funds Target, Markets and FOMC Forecasts

Comment # 3 – Spared Bond Market Volatility (to Date)

The sharp uptick in equity volatility has to date not been replicated in bond markets which remain relatively benign. That said, bond yields and therefore bond prices have been moving significantly over the last 6 months. US 10 Year Treasuries have risen from 2.34% in September 2017 to 2.83% as of now. The direct result is increased interest rate risk with a drop in values. This, therefore, sees a reduction in prices for bonds and equities concurrently, which means little if no diversification benefit.

Cameron Harrison’s Interest Bearing Strategy does not currently carry any significant duration risk which immunises the strategy from rising interest rate risk to capital values.

Ex-Resources High Yield and Bond Volatility

Diagram showing Ex-Resources High Yield and Bond Volatility

Comment # 4 – The Best of Times and the Worst of Times

In economic assessment terms the developed world is experiencing the best of times (at least relative to the post GFC environment of the last 10 years). These best of times, particularly in asset markets (property, equities, bonds and commodities) have in large part easy, accommodative credit to be thankful for. What we are seeing is some tightening in the availability of labour (through lower unemployment and higher wages) and in capital (withdrawal of quantitative easing). The result is that we are seeing financial markets catch up and as tends to be the case, equity markets have lagged bond markets and the catch-up is proving quite jolting.

Global Purchasing Managers Index and 10-Year Treasury

Diagram showing Global Purchasing Managers Index and 10-Year Treasury

For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.