As a result of the crisis, central banks around the world have lowered their key interest rates and engaged in unconventional easing measures. This has led to an unprecedented decline in government bond yields in developed market (DM) economies, despite recent steep corrections in yields on, for example, German Bunds in April and May this year. Multi-asset funds give investors the opportunity to replace part of the interest rate risk they face in their bond portfolios with potentially better rewarded opportunities in other asset classes, without increasing the overall portfolio risk. When we return to an environment of greater investor confidence and improved global growth conditions, persisting global economic and monetary policy divergence will continue to lead to return differences between and within asset classes. Regions will be in different phases of the cycle and sectors will respond in a variety of ways. Furthermore, the frequent occurrence of unexpected events also rewards those investors with the ability to change views quickly and act accordingly.
Ongoing uncertainty about emerging markets (EM) caused a spill over into DM assets in August and September, resulting in a sharp rise in DM equity market volatility. Volatility rose much more compared to other periods of uncertainty in past years. In fact, the volatility spike (as measured by the VIX) was comparable with late 2011, although the duration of severe uncertainty was much shorter. Currently, volatility is still elevated, but has come down from extreme levels.
At the centre of the uncertainty were emerging markets. The Chinese currency devaluation drove many other EM currencies down. These currencies have been weakening for some time now and quite a few currencies have fallen significantly against the US dollar since the start of the year. The spill over of the EM volatility was most noticeable in equities and commodities. Other risky assets were also not spared and we saw for instance a widening of Euro area investment grade and high yield spreads.
One important way in which the EM turmoil is impacting DM government bond yields is through inflation expectations. EM weakness has resulted in declining commodity prices, which have strongly impacted inflation expectations over the past year. In case the market would be worried about the overall outlook for global economic growth and monetary policy, also the real yield would decline. This is however not the case at this stage. There is still a slight upward trend in real yields in the US and the Eurozone. Whether this trend continues will depend on the level of contagion of the EM crisis into the DM growth environment.
In the medium term, we expect a moderate global economic recovery which supports risky asset fundamentals. From a monetary policy perspective, we expect the Fed to move slowly on its path of normalizing monetary conditions, which implies a process of slowly increasing bond yields in the coming years. In the Eurozone and Japan monetary conditions are still being loosened. The result of this is that, on a net basis, global liquidity continues to expand. However, the transition into policy normalization by the Fed may result in increased market volatility. We expect to remain in a relatively low inflation environment for the time being.
For the moment, markets do look fragile with a life of their own. The EM environment remains very weak, with the potential of a spill-over into DM. We have adopted a more defensive asset allocation stance over the past couple of weeks. As markets are to a large extent driven by short-term sentiment and news currently, volatility is expected to remain high. In such market circumstances, value can be added by adapting to market behaviour in order to exploit new opportunities available in the cross-currents of underlying fundamentals and market behaviour.
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