We can point to a number of reasons for the current risk-off environment, the most important of which has been an overwhelming global repricing of deflationary risks.
Whether or not we may be on the cusp of an economic recession (we don’t think so) it’s clear that after five years of unconventional monetary policy bolstering markets, a recession is not required to see lower asset prices. The market is going to continue to struggle to price China risk, as it seeks to digest the implications of China seeking to support its export sector via yuan devaluation. We may be at something of a hiatus in the market falls currently, but expect this issue to continue rearing its head.
Performance of indices over 1yr
Source: FE Analytics 
What we’re seeing is a tightening of liquidity globally meeting a downdraft in earnings driven by deflationary trends. Our central case remains that the US economy is on solid ground, and that a recession is unlikely, but it is clearly unrealistic to expect a balanced portfolio of long equities and stocks to generate the returns it has in the last few years.
Due to very rich valuations, fixed income is effectively stuck and no longer providing balanced investors with diversification relative to equities. Investors seeking both returns and true diversification will need to seek market return strategies beyond a traditional balanced portfolio, tapping into areas such as derivatives, currency trades and volatility trades.
We’re positioned relatively defensively in our traditional market-based strategies, such as long positions in healthcare, telecoms and financial stocks. Across the board our portfolios have a lower appetite for risk generally, with equity exposure having come down over the last year.
Significant positive returns in the last six months have come from currency, where we have been able to efficiently reflect our macro themes and get better diversification relative to equities through profitable positions such as being long the US dollar versus short emerging market Asian currencies.
Performance of Elliot vs peer composite over 6months
Source: FE Analytics
Furthermore, in December, we bought put options on the Japanese yen, which we felt would rise as a safe haven asset, and because we felt the market was significantly underpricing tighter liquidity risks.
Advanced derivative strategies have been another source of strong positive returns in recent months, as we have picked up positive performance from underpriced volatility, informed by our concerns over tightening liquidity and the stronger US dollar acting as an effective tax on liquidity.
In our view, finding positive returns from diversified sources relies on tapping into macro trends driving global capital markets. These can give rise to specific thematic investment ideas, either through more traditional market beta-linked returns, like long positions in equities and bonds, or more sophisticated strategies that are not reliant on the direction of the markets to generate returns.
We focus on eight macro themes driving global markets in order to translate those themes into returns, by capitalising on the varied multi asset investment opportunities created by these trends. Current themes include:
Low inflation
Inflation remains low across the developed economies and many emerging economies. Loose monetary policy has driven a search for yield, supporting duration assets and leading to valuation expansion and potentially to asset price bubbles. The main cyclical drivers are debt deleveraging in the wake of the financial crisis, and global industrial overcapacity.
Global policy divergence
Varying degrees of policy accommodation and economic growth have led to divergent level of slack across regions. The resulting policy divergence should result in interregional yield curve and currency opportunities.
Performance of indices over 1yr
Source: FE Analytics
Supply side weakness
Low developed market productivity and labour force growth may lead to lower trend rates of economic growth in the long term, and raise capacity pressure leading to earlier rate hikes in the short term.
US economic strength
The US economy is in the middle of a long and relatively flat business cycle. The housing market and employment continue to recover, the consumer appears to be benefiting from lower oil prices, and corporate balance sheets are strong. The Federal Reserve (the Fed) is moving closer towards an interest rate hiking cycle.
Europe gradual growth recovery
Several forces that were weighing on economic activity are lifting. Policy is also expected to remain supportive, but politics remains a key risk.
Japanese economic recovery
The Japanese economy is gradually accelerating although the data remains choppy. Abenomics has been a mixed success in bolstering cyclical and structural growth. In spite of progress, the Bank of Japan is still missing its inflation target.
Emerging markets rebalancing
Growth is moderating as the region transitions from debt-fuelled infrastructure-led to consumption and productivity-led growth. Higher funding costs, a stronger US dollar through US monetary policy tightening, and lower commodity prices make highly-levered commodity-sensitive emerging markets unattractive. Lower future growth prospects in China reduce demand for emerging economics geared towards manufacturing.
China in transition
China is transitioning from high to moderate growth, and from investment-led to consumer-led growth. Commodity prices and commodity-producing economics will be negatively affected. Other economies may feel the impact of lower Chinese demand for their exports. The rapid rise in debt in recent years raises the risk of a disorderly slowdown and a financial accident.
James Elliot is the chief investment officer of Multi Asset Solutions EMEA at JP Morgan Asset Management. The views expressed here are his own and should not be taken as investment advice.
