Although there has been growing scepticism about the strength of the current equity market, the year so far has been characterised by falling volatility to near historical lows, as measured by the VIX index.
Performance of index in 2014
Source: FE Analytics
This has raised concerns that complacency abounds and a sharp correction is around the corner.
However, Merricks (pictured), head of investments at Skerritts, says low volatility may remain for longer than expected and that the suspected catalysts of such a correction have been overstated.“It is unquestionably a worry that volatility has reached one of its lowest measures in a decade, but this doesn’t necessarily predict an instant reaction.”
“In 1993 when it was this low, it took some six years to hit a peak in 1999, having drifted only marginally up for the four years before that. At a similar level in 2004, we know that it took four years to explode.”
Merricks says negative real interest rates and bond yields mean there are risks, but that the market may be overcompensating for a crash.
“Yes, we see threats looming through current valuations and low volatility. Yes, we see threats in the shape of geopolitical issues in eastern Europe, eastern Asia and the Middle East. Yes, we see very real threats emerging as we move nearer to the day that interest rates actually rise on either side of the Atlantic. But are these threats sufficient for us to run to the hills seeking cover? Not yet,” he said.
With this in mind, Merricks highlights three of the biggest perceived risks facing the current market and analyses how dangerous they really are.
Rising interest rates
After five years of historically low interest rates, the Bank of England and the Fed have begun to hint at a reversal of accommodative monetary policy.
“Rising interest rates are an inevitability at some point since they fell to zero, but the timing of the rise is still unknown. There have been a few false dawns and the markets have not reacted well to them. This is an obvious risk,” said Merricks.
The UK is expected to lead the way with governor of the Bank of England Mark Carney implying they are likely to rise in the last quarter of 2014.
Several high-profile managers have said that the process is one of the major headwinds that could knock back markets.
“To what level they rise and over how long will almost guarantee an uncomfortable few weeks when it happens as markets try to work out an answer. At this point there will be both risk and opportunity,” said Merricks.
He adds that higher interest rates can present a problem when they are triggered by stronger-than-expected inflation.
“If it looks like it [inflation] is growing too strongly, the banks will raise interest rates more. This is the scenario that the markets will be trying to get to grips with when they go into recalculation mode, which we suspect will trigger a fall.”
However, he says this is unlikely.
“We don’t think that once they’ve recalculated, they will be too alarmed by what they see, so our guess is that any volatility for this reason will be relatively shallow, albeit uncomfortable.”
Geopolitics
The Russia/Ukraine crisis and numerous skirmishes across the Middle East have all looked worryingly contagious to financial markets.
Some experts have said that geopolitics currently poses a greater threat to investors’ portfolios than it has done for years, which is evident in the sharp losses in the markets connected to the crises.
For example, our data shows that the MSCI Russia index is down 13.19 per cent this year while crude has risen by almost 6 per cent.
Performance of indices in 2014
Source: FE Analytics
“We would argue that their effect on global markets is nowhere near as potentially dangerous as the credit crunch and eurozone crisis that we have endured recently,” Merricks said.
“Admittedly, we are not rushing to buy Russian equities and we have added a modest holding in oil to our more aggressive growth portfolio as a possible hedge against increasing tensions in the Middle East, but we are not fretting about the wider markets as we have done about other issues.”
However, Merricks says he is concerned about rising tensions in eastern Asia, which he says is being forgotten due to the Middle Eastern and Ukrainian conflicts.
“A spat between Vietnam and China for example would be extremely unsettling to the Asian markets, and because of their deeper influence, quite possibly to global markets as well. But this is not a risk that we can necessarily defend against in advance, so we remain unprotected against such a move.”
A European banking crisis
Panic quickly spread through markets in July when the Portuguese bank Banco Espirito Santo revealed huge previously hidden losses.
This caused concerns that another European banking crises was around the corner.
“This was not good news for our investment strategy that consists of being overweight the European periphery – Italy, Spain and Greece – in our portfolios,” Merricks said.
When the news broke at the beginning of July, markets in peripheral Europe, such as Spain, Italy, Greece and Portugal, all fell significantly.
Performance of indices over 1 month
Source: FE Analytics
However, Merricks is maintaining an overweight position to the south of Europe.
“The European Central Bank has baulked up its stress-testing of European banks, and what happened to Espirito Santo was exactly what the Asset Quality Review was designed to do – namely flush out the skeletons in the cupboard.”
“It appears that most of the European banks are adequately covered and those that fail – such as the Portuguese one – will not pose a risk to the system.”
“At the same time, there are strong signals that the Spanish housing market may have bottomed out and that European bank lending in general has once again turned positive. So if the banking system itself is not threatened, the biggest beneficiaries of improved sentiment towards banks will be those very indices that have a higher weighting towards them.”
