A Reality Check

Alex Scott, Chief Strategist, Seven Investment Management (7IM)

For the first time in over a year, markets have fallen sharply. Keeping a cool head about markets is important when others are panicking. We believe that there will be opportunities for those able to take a long term perspective.

We have been living through extraordinary times for markets. Through 2017, we experienced the lowest levels of equity market volatility in a generation. In January, investors were contemplating a market ‘melt-up’, as US stocks enjoyed their best start to the year in over two decades and reached their longest ever period without a 5% correction, topping 400 days. How quickly investor sentiment can change.

Yesterday’s 4.5% negative move in the S&P 500 is something investors haven’t experienced since 2011, so where has this come from? Stronger-than-expected US wage data on Friday reminded investors that inflation risks are building and that the Federal Reserve will continue to increase interest rates. With other central banks winding down their Quantitative Easing policies, investors are worrying about the end of the cheap money era which has underpinned market confidence and valuations over the past few years. Bond markets wobbled, with US Treasury yields reaching close to 3%. Equity markets losing their previous dead-calm complacency is a surprise for many investors – but it is important to note that even with all of the terrifying headlines, the S&P 500 is only just negative on the year.

We have recently been highlighting the challenging environment for investors. The global economy is in good shape, with data continuing to point towards synchronised growth across the major blocs of the US, Europe and Asia in the year ahead, even a possibility of acceleration if corporate capital spending improves. It would be extremely unusual to see a sustained or deep equity bear market against such a positive economic background. Set against this, we have been concerned by demanding equity valuations and by apparently complacent investor sentiment, evident in such low stock-market volatility. With levels of volatility so low, there is a risk that a small rise could lead to a larger market reaction, as investors receive a reality check. Recent low volatility is the exception and not the norm, so there may be a few people (and programs) scrambling to recalibrate their risk models and a need for some to reappraise whether they have taken on too much risk.

Our strategy over recent months has been to operate with some caution: to participate to a degree in the very strong stock market momentum, but to remain underweight equities overall, and looking to include other defensive measures where possible. We have been very wary of government bonds, especially gilts and European government bonds, where yields remain too low. We have built up allocations to alternative strategies, which aim to be uncorrelated to the direction of equity and bond markets, and may be partially sheltered from an equity market shakeout such as we are now witnessing. Finally we have continued to hold high levels of cash and very short-dated bonds (as high as 12% in a Balanced portfolio across cash and short term bonds currently), awaiting more advantageous opportunities to invest. These may soon appear.

This episode of market volatility has not yet played out and could well involve more wrenching trading sessions for investors. Central banks are moving towards a more normal interest rate policy, and this will see some of the distortions of the last few years unwinding – not always smoothly. But the economic cycle has not yet turned, the growth outlook remains healthy, and this suggests that we face a market correction, not a sustained downturn or a recession. 7IM portfolios will see losses from their market exposure, but lower than average equity weights and high cash allocations, as well as our other defensive measures, should mitigate the pain and provide chances to invest cash into attractive assets at much more appealing prices. For investors with a long time horizon and robust portfolios, periods such as this offer opportunity. We will keep you updated.

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