An inevitable financial crisis in China, a Fed rate hike and political strife across Europe are the three major risks facing the current market, according to LGIM’s Justin Onuekwusi, who has been heavily reducing his exposure to equities over recent months to protect his investors. 
Though few would have expected it before the vote, global equity markets have rallied considerably since Brexit became a reality in late June. According to FE data, the MSCI AC World index has made some 18 per cent since the EU referendum despite the political and economic uncertainty it has created.
The reasons behind the rally (for UK investors, anyway) include sterling weakness and monetary easing from the Bank of England – as well as the usually thin summer trading volumes.
Performance of index since EU referendum
Source: FE Analytics
However, many are becoming increasingly concerned that equity markets are becoming complacent. Indeed, the VIX index (often dubbed the ‘fear’ index), recently dropped to its lowest level in two years as volatility has subsided.
Onuekwusi, whose five passive multi-asset funds in the L&G Index range are all top-quartile in their respective sectors since launch, is one such manager who has become worried about the outlook for equities.
“The most important element to stress is that we are cautious on risk assets,” Onuekwusi said.
“If you take a medium term view, we think risk assets will deliver a lower return than their long-term average. Therefore, we are tilting the portfolios to be more cautious by, essentially, cutting our equity exposure right across the board since 24 June.”
“We think the equity market reaction [to Brexit] has been driven by liquidity rather than fundamentals, rates being lower for longer, essentially, and that has pushed markets up to the levels we have seen today.”
“We haven’t seen an improving earnings outlook or growth outlook, in fact, you’d argue that the growth outlook now is worse than it was pre-Brexit.”
He says there are three major reasons why he has been selling his equity exposure and upping his cash levels.
An inevitable Chinese financial crisis
First and foremost, Onuekwusi is concerned that a ‘hard landing’ in the Chinese economy (the second largest in the world) is now almost certain given the way the country’s authorities have changed their tact to appease investors.
“We think it is now inevitable that over the next two to three years China will have a financial crisis,” he said.
While China was the perennial source of bad news for global markets in 2015 and during the earlier stages of 2016 (its stock market bubble burst, the devaluation of the yuan caused August’s Black Monday and its equity market closures in January created yet another sell-off), there have been signs of stabilisation over recent months.
Indeed, FE data shows the Shanghai Stock Exchange Composite index has returned 30 per cent since its lows in January (though it is still down 9 per cent over 12 months).
Performance of indices over 1yr
Source: FE Analytics
However, the L&G manager says the recent ‘stabilisation’ in markets has been driven by short-sightedness from the Chinese authorities and warns that the sheer levels of debt in the economy are of great concern.
“If you go back in history and you see just how much debt they have accumulated versus their trend, it is a huge concern. They need to de-lever their economy and in January 2015, that is what they were doing. Since the middle of last year, they started to inject liquidity and re-lever and that is what they did not need to do.”
“Ok, it’s driven up the Chinese equity market and property market, but it simply kicks the can down the road. They have to try and de-lever their economy because they are borrowing at too quick a pace.”
The Fed moving faster than the market is anticipating
This risk seemed to have been put on the back-burner, but Onuekwusi says that recent developments in equity markets have brought it back to the fore.
For much of last year, it was expected that the US Federal Reserve would pave the way for a normalisation in monetary policy by increasing interest rates from the levels implemented during the global financial crisis.
Despite a period of ‘will they, won’t they’, Janet Yellen and co eventually increased the Federal Funds Rate in December and the guidance from the central bank was that four further hikes would be implemented in 2016.
Fast forward to today and rates have not moved as the Fed has become increasingly global-facing, worrying that any tightening could create problems for financial crisis and foreign economies.
Though many believe another hike is out of the question for now (especially given most other central banks have been easing policy), as there are returning inflationary impluses and risk assets are soaring, Onuekwusi warns the market is becoming very complacent about the outlook for US interest rates.
“The second risk is the Fed increasing rates quicker than the market expects. We’ve had a dress rehearsal of this. At this point last year, everyone expected the Fed to raise rates at some point in H2, ok they did it in December, but arguably that caused a lot of volatility in markets and in particular in emerging markets.”
Performance of indices in the two months after the Fed’s rate hike
Source: FE Analytics
“The more markets carry on the way they are and show no visible effect from Brexit, it puts Fed rate hikes back on the table and that is a concern to risk assets.”
A potential political mess
The final risk is the potential for severe political uncertainty in Europe, which Onuekwusi says has been the major reason as to why he has been selling down his exposure to risk assets.
“That captures Brexit, there is still a huge amount of uncertainty. When will Article 50 be invoked or will it ever be invoked (I read recently that people are talking about it happening in 2019). There is just so much uncertainty around the political environment in Europe at the moment and it spans outside of the UK.”
He points out that there is to be a referendum in Italy on constitutional reform which could lead to the resignation of the country’s prime minister and a referendum in Hungary on immigration over the coming few months.
On top of that, he notes that there are elections in Austria, Holland, France and Germany between now the end of next year which could have significant ramifications for the European economy (and its markets) given the rise of far-right populist parties across the continent.
“Clearly, this environment in Europe isn’t sustainable because a third of the European parliament is now, essentially, made up of anti-European parties. We do think you are going to see a lot of political stress which will put stress on the sustainability of the European Union as well as the Euro.”
