It is difficult for financial markets to make headway over the summer months when trading is thin and relatively little is happening in the world economy. As a result, an astonishing 97% of global stock market returns since 1973 have accrued during the seven months from October to April. Volatility also tends to reach its peak in October, underlined by famous crashes in 1929, 1987 and 2008. Cross-currents in the world economy are causing volatility again this October as financial markets engage in a tug of war between good news coming out of the US and bad news out of China.
Royal London’s Investment Clock, which relates the performance of different investments to the global business cycle and guides the firm’s asset allocation, is in ‘stagflation’. Economic growth is slowing outside of the US, inflation is rising from low levels, and the Federal Reserve is raising rates. This is usually a bad configuration for stocks, but we are in a two-speed world; China is slowing while President Donald Trump’s tax cuts and spending increases keep the US economy strong.
Emerging economies are under threat. Weaker activity in China is putting downward pressure on exports and US interest rate increases are raising the cost of dollar finance. Add in concerns about trade wars and geopolitical instability and it is easy to see why emerging markets are in bear market territory, down more than 20% since their January highs.
Meanwhile, US equities reached new highs only recently, supported by the second longest economic expansion in the country’s history. Unemployment has fallen to 3.7% from 10% in 2009. A tighter labour market eventually stokes wage inflation, but US interest rate rises have been modest to this point.
Investor sentiment has taken a knock on the back of concerns over Fed rate rises and trade tensions, but October volatility presents an opportunity for buying stocks. With US fiscal policy loose, interest rates low elsewhere in the world and China easing policy to offset trade war fears, the economic expansion can be expected to continue into 2019.
Circumstances in Europe are much more difficult to forecast; it is hard to prepare for Britain’s exit from the European Union while the shape Brexit will take remains unclear. The UK could leave the EU with a wide range of future trading arrangements lined up. The final decision will probably come late and involve last-minute and unpredictable compromises.
The impact on sterling and gilt markets will be different in each scenario. The more disruptive outcomes would probably lead to a rally in gilts and a slide in sterling as the Bank of England kept interest rates lower for longer. An outcome close to EU membership could cause gilt yields to rise and the pound to surge on foreign exchanges.
Given the uncertainty, it is inadvisable to structure portfolios for a particular outcome. This is about hedging risks.
Trevor Greetham is Head of Multi Asset, Royal London Asset Management.