Keep Calm and Allocate

A rash of fears have overtaken markets. Over the past four weeks, the VIX (volatility index – aka “the fear index”) has risen 86% whilst global equities have slumped 7.6% and emerging market equities have fallen by 6.8%. On Wednesday 10-year US Treasuries touched a 17-month low at 1.86%, whilst 10-year Gilt yields closed at a 26-month low of 1.96%, and Bunds at an all-time low of 0.76%.

The sell-off has been largely driven by concerns over the Fed’s removal of QE, deflation in Europe, the slowdown in the Chinese economy, and even the possibility of an Ebola pandemic. Although cognisant of these risks, we believe this is a “glass half empty” view.

The “half full” view is that the largest economy in the world is now seeing a steady recovery, highlighted by US housing prices returning to pre-crisis levels. Unemployment in the US has fallen to 5.9% in September, and it was recently announced that the budget deficit has fallen to its lowest level since 2007. With inflation seeming to be well contained, the Fed has plenty of flexibility to tighten in 2015 – or not, if the economy does not appear to be continuing on this positive trajectory.

Whilst Europe seems now to be on a path quite similar to the one taken by Japan two decades ago, we do not believe that policymakers will let it get there. Echoing the famous words of Winston Churchill we believe the ECB, and even European politicians, will eventually “do the right thing – after they’ve tried everything else.” The structural impediments in Europe are clear, but then again the lessons of Japan are on everyone’s minds.

In emerging markets, the story has become choppier. Whilst Brazil and Russia are struggling for different reasons, both China and India are demonstrating their willingness to pursue deep economic reforms. Yet recent trade data for China showed that exports rose by 15.3%, whilst imports also climbed 7.0%. In India the new reformist government is making headway on its new economic policy with a focus on reducing the government deficit, and promoting manufacturing and infrastructure. These two economies, which hold over a third of the world population, have the potential to drive global growth over the long term.

On top of all of this, the recent drop in oil prices, if sustained, could provide a whopping $1.1 trillion stimulus to the global economy.

Since the trough in equities in June 2013 stemming from the first “taper tantrum,” the MSCI World Index rose 24% to its peak in September 2014. It is clear that right now many investors are being swayed by fear. We prefer to keep calm and allocate (or rebalance back) to risk assets where appropriate.