Market review: volatility to continue, but with some positive signs

Andrew Milligan

In his regular review of markets, Aberdeen Standard Investments’ Andrew Milligan considers the impact of the Brexit extension and UK election announcement. He also looks at the outlook for European markets, the impact of the US-China trade war and the risks associated with the long low interest rate environment.


Brexit extension and election announcement signal continued uncertainty

The European Union’s issue of an Article 50 extension coincided with the news that a general election will after all be held in the UK before Christmas. Although this makes a hard Brexit less likely, financial markets now have to price in some uncertainty about the election result as opinion polls have been known to be incorrect.

There have been signs that overseas investors are becoming more interested in UK assets. But we expect them to hold off until the result of voting is clearer – whether there’s a government with a majority which can push a Brexit Bill through Parliament or, conversely, whether UK politics will remain rather divided.

Green shoots for Europe and an end to the US-China trade war?

There are various signs that the European Central Bank is managing to support the growth of credit across the Eurozone, even if the outcome is rather weaker than needed to make sure inflation returns to the bank’s target. However, external events look to be rather more important in helping support the German economy, and more broadly European equity markets.

Meanwhile, further afield there are strong suggestions from diplomats that later in November the US and China will agree a truce on trade matters. In return for larger Chinese imports, for example of US agricultural goods, the US might agree to halt its tariff increases on Chinese exports into the US.

There’s clear evidence that the US-China trade conflict has had some effect on the world economy, especially business investment, although it should be emphasised that the downturn in global manufacturing has other causes too. These include the lagged effects of monetary policy tightening in China, the headwinds to car purchases and the broader auto industry due to regulation and the shift from diesel to electric cars, plus a downturn in smartphone demand.

Both the US and China are suffering too, with Chinese gross domestic product (GDP) the weakest since 2009 and US GDP stuck in a below-trend range. Neither of these cases is helpful for Presidents Trump or Xi in an important year for both of them.

Together with signs that business surveys are stabilising and company profits remain relatively buoyant, the potential truce to the US trade tensions with other countries has helped global equity markets start to break through to new highs.

No one expects a rampant bull market, but the withdrawal of bad news may help previously cautious investors put some of their excess cash to work in previously unloved cyclical markets such as Europe and the UK. Matters could improve further if there are definitive signs that the global growth slowdown is coming to an end.

A word of caution – volatility is here to stay

Volatility is a fact of life which investors must learn to live with. Compared with previous decades, investors face a world of growing political risk, as President Trump’s torrent of tweets clearly demonstrates. Meanwhile, all financial markets are much more beholden to central bank policymaking – quantitative easing and negative interest rates are a historically unusual phenomenon.

The key issue for investors therefore is to learn to love volatility – after all one of the best times recently to buy global equities was in the unexpected sell-off at the end of last year on the back of poor trade news. In broad terms, continued market volatility supports the use of more diversified funds, including a wide array of public and private markets, as well as multi-asset styles of investing, ones where a great deal of scenario analysis is put to work and portfolios are rigidly stress-tested for dangerous outcomes.

The only financial asset which won’t be affected by volatility is cash, and that of course has drawbacks in the form of very low returns in the current low interest rate environment. Financial theory tells us that higher levels of return require taking on board higher levels of risk.

Opportunities in volatile markets

Despite volatility in markets, there are signs of relatively positive global growth. As a result, we see benefits from some higher growth equities, such as the US, Japan and selected emerging markets, as well as some higher yielding debt – both corporate and emerging market.

However, we need to be very wary of the possibility of a policy mistake leading to a recession in the next year or two, especially if politicians make errors. On that basis, less volatile assets would include safer grade bonds – whether government or corporate – as well as private assets or real estate with strong balance sheets. However, even in such an environment some equity markets will do better than others – the US is an example because global capital flows back home – or investors will look for safer sectors such as pharmaceuticals and utilities. When creating an investment portfolio, the timescale becomes ever more important.

Continued low interest rates carry some risks

A number of bodies such as the International Monetary Fund and Bank for International Settlements, as well as individual central bank governors, have been warning of the risks of a continued environment of negative yielding interest rates and bond yields.

Firstly, because of such a narrow spread between borrowing and lending money, it’s difficult for many European and Japanese banks to make profits. Negative interest rates also make it more difficult for households to save enough money, so many individuals delay big purchases, such as buying a house, to try and save even more.

A less obvious impact of low rates is that they allow many ‘zombie’ companies to stay alive. This prevents labour and capital from being recycled into new ventures, helping restrain the rate of economic growth.

Meanwhile in the public sector, low borrowing costs reduce the need for politicians to take hard decisions about public spending, taxes and regulation. Public sector debt levels may be high but government borrowing is very easy to finance. The debate has begun about whether more proactive fiscal policy is needed to support economic growth but, until there’s some form of crisis, it looks like governments will rely on central bankers to help sustain activity.

The information in this article should not be regarded as financial advice. Please remember that the value of your investment can go down as well as up and may be worth less than you paid in. Information is based on Aberdeen Standard Investment’s understanding in November 2019