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The second quarter was a consolidation period for most asset classes. European equities took a breather after the French election result only to start moving lower towards the end of the quarter. US and emerging market equities, on the other hand, delivered strong results.
In the fixed income space, curves initially flattened during the period only to end with core rates rising and steepening during the final days of the quarter on the back of a synchronised hawkish tone by the major central banks. Commodities remained on the side lines with surging crude oil volatility and metals in a range bound trading pattern.
The recent underperformance of US macro numbers will not last long.
Several events are important this quarter from political and economic perspectives. First and foremost: the outcome of the French presidential elections will trigger repricing across asset classes. We remain optimistic and confident that a pro-Euro, pro-free market candidate will win and this will favour our long European equities / short German bunds investment theme.
What stood out during the quarter were the continuation of the “fade Trump” trade (through the weakening US dollar) and the low levels of fixed income and equity volatility. The greenback lost 5 per cent against its major trading partners – driven by improving macroeconomic fundamentals outside the US and the US administration’s failure to deliver on its pre-election promises. The argument that the US dollar is becoming a price taker as opposed to a price setter may have significant implications for various asset classes around the world. The recent underperformance of US macro numbers compared to expectations will not last long: we still see favourable growth and job market conditions. Nevertheless, the renewed hawkishness from ex-US central banks combined with improving conditions gives non-US assets more upside potential, be they Eurozone or emerging markets.
As the passive share of the market increases, average volatility should become subdued.
In addition to the large shadow cast by central banks, the low volatility puzzle can be explained by two further factors. Firstly, we witnessed the fast adjustment of investors aligning expectations with reality against surprising political events. Volatility and economic surprises move in lockstep and as recent events (the Brexit vote, Trump’s surprise win and the Italian referendum) have shown, equity markets are resilient. They digested these events then went back to scaling new heights with remarkable calmness. Secondly, the increasing dominance of passive funds and exchange traded funds in the US market. Passive investing now accounts for $6,000bn of global assets and makes up almost one third of the AUM in the US. Lower fees, new technologies and financial regulation have all conspired to boost the passive phenomenon. As the passive share of the market increases (it’s expected to reach 50 per cent of the market by 2024) and investors further embrace beta (smart or not), average volatility should become subdued.
We maintain our long equities and short bonds view.
Stepping into the third quarter we maintain our long equities and short bonds view. Benign (healthy) inflation coupled with strong macroeconomic fundamentals supports our view even in an environment where central banks start turning hawkish and discussing steps to withdraw their excessive accommodative policies. Within this context, investors should be very selective and form directional or market neutral views with a high degree of conviction in order to avoid either benchmark traps or consensus ideas.
In this quarter’s outlook, we have again extended our country coverage and increased the number of investment ideas we offer. As ever, our goal is to share a broad range of ideas across all asset classes – always substantiated by our own in-depth research and high conviction.
FOR PROFESSIONAL INVESTORS ONLY