Asset classes are starting to behave in different ways, as we move into a new stage of the risk cycle.
Take the chart below, for example. Up until April, the S&P 500 Index and the MSCI Emerging Markets Index were moving broadly in tandem, both responding positively to a generally risk-on environment, even with similar down moves in the market shakeout in February. However, since April, their relationship has broken down. US equities have since hit new highs and emerging markets have continued to move lower.
Source: Bloomberg, 11/09/2017 – 10/09/2018.
Around the same time, Italian government bond yields, which had been converging towards German yields for the previous twelve months, saw their relationship break down too, as the spread between Italian and German bunds widened materially.
What was the trigger for these events and were they related? There are a number of similarities. As we have mentioned before, tighter US liquidity, in the form of a stronger US dollar (which moved higher in April and May) and rising US interest rates introduces a more punishing backdrop for assets generally and forces investors to be more discerning: ‘the survival of the fittest’.
This is relevant here as debt sustainability is becoming more of a focus, especially when the domestic political environment is fragmented, with coalitions or weak minority governments. The Italian election in March resulted in a coalition of two populist parties with very different positions and this shone the light on Italy’s debt sustainability, against the background of an ECB looking to end its asset purchase programme.
There are similarities with other countries too, for example South Africa, Turkey and Brazil. Certainly, debt sustainability and a domestic political environment which, for whatever reason, limits the ability to build consensus around effective crisis-fighting policy measures is looking like a dangerous combination again.
How can this inform us going forward? The economic environment looks pretty robust globally with above trend growth and inflation only edging upwards slowly. Central banks are keen to exit QE and, particularly the Fed, has been pretty clear on the type of rate profile they envisage, i.e. rates moving up gently but consistently. So far so good: this is pretty supportive for financial markets generally and we feel fairly comfortable establishing a base case and building in some scenarios around that.
However, politics is a different ball game. Markets have always struggled to price political risk and we do too, especially in the new world of politics where the period of traditional parties passing traditional policies feels long gone. More populist, nationalist and fragmented political landscapes are even more difficult to gauge. Markets are more sensitive to political risk now and it’s not going away anytime soon, with a fairly full pipeline of events coming up, including US mid terms, Italian budget proposals, Brexit negotiations and a Brazilian election. Our approach is to manage political risk, rather than look to generate returns from political events.
More generally, against the ‘survival of the fittest’ backdrop, we have reduced our emerging market exposure significantly and have added to US equities, particularly the US consumer. We also continue to stress-test our portfolios to try to ensure that we’re not too exposed to political risk.
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Source for information: Miton as at 11/09/2018 unless otherwise stated.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
Miton has used all reasonable efforts to ensure the accuracy of the information contained in the communication, however some information and statistical data has been obtained from external sources. Whilst Miton believes these sources to be reliable, Miton cannot guarantee the reliability, completeness or accuracy of the content or provide a warrantee.
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