The recent sell-off in risk assets has provided a timely reminder for investors on the threat of volatility to portfolios following a becalmed start to 2019, according to BlackRock’s Katy Moore and Scott Thiel.
After a volatile 2018, markets have been more subdued in 2019 as some of the major macroeconomic and geopolitical challenges seemed to have been resolved.
A pausing of the Federal Reserve’s path to normalisation and slowing but growing global economy helped markets to a strong start to 2019.
However, that calm was shattered last week as US president Donald Trump’s decision to levy increased tariffs on $200bn worth of Chinese goods put a trade war back on the agenda.
With China retaliating, volatility has returned to markets as the expectations of a trade deal have faded.
As the below chart shows, the CBOE SPX Volatility VIX – the so-called ‘Wall Street fear gauge’ and a measure of 30-day expected volatility of the US stock market – has lifted in recent days.
Performance of index YTD in US dollar
Source: FE Analytics
Now that hopes of an imminent deal seem dashed, should investors prepare for greater volatility this year?
“The market outlook had become more benign this year, following a sell-off in the last quarter of 2018,” said BlackRock chief equity strategist Moore and chief fixed income strategist Thiel.
“Last week’s market moves serve as a reminder that unusually low levels of market volatility likely do not accurately reflect the risks in this late-cycle period.”
The market’s attention on global trade tensions had dropped sharply from mid-2018 peaks, according to the pair, noting a drop-off in chatter about the risk in analyst notes and in traditional and social media.
“This was pointing to greater potential for market volatility should the risk flare up, as it has over the past week,” they said.
While the prospect of a trade deal has not been extinguished completely, it may become more difficult for both sides to come to agreement.
“We could still see a US-China trade deal that includes a Chinese pledge to purchase more US goods, among other items, yet implementation and enforcement will be challenging, in our view,” said Moore and Thiel.
The asset manager has previously noted that the US-China relationship has transitioned from a broadly cooperative state to a more competitive phase.
It has warned that any tensions between the pair are likely to be structural and long-lasting, warning investors that they “should not confuse any trade truce with a détente in the overall relationship”.
US-China competition risk
Source: BlackRock
The asset manager believes that markets are too narrowly focused on the trade dispute and are failing to appreciate the complexities of an “intense technological rivalry”.
Despite the recent downturn in markets, the BlackRock strategists remain “cautiously pro-risk” albeit with the potential for further bouts of volatility in the late-cycle period.
Risk assets remain in favour with the pair due to the ongoing global economic expansion and the prospects for central banks to remain accommodative.
“To be sure, we see major central banks on hold in the months ahead, providing a stable policy backdrop,” said Moore and Thiel.
Yet, increased macroeconomic volatility – as reflected in the dispersion of analysts’ GDP forecasts – have historically featured greater market volatility.
“US growth is slowing and economic data could become more noisy in the months ahead after a sharp inventory build-up in the first quarter,” said the strategists.
China itself could prove another potential source of volatility, according to Moore and Thiel. Despite having seen signs of a growth recovery, the scale and longevity of the Chinese government’s stimulus package could soon be called into question.
As such, investors should maintain some ‘ballast’ in their portfolios, arguing for a balanced approach for the remainder of the late-cycle period.
Moore and Thiel noted that US Treasuries have historically played an important role in cushioning portfolios against bouts of volatility.
“The traditional inverse relationship between US equity and government bond returns is alive and well,” noted Thiel. “We see the negative correlation being sustained in this late-cycle period, with Treasuries acting as a buffer to any sell-offs in risk assets driven by growth scares”
Performance of US Treasuries vs S&P 500 YTD in US dollar
Source: FE Analytics
Whereas in equities, the asset manager continues to favour the US and emerging markets, with a bias on quality stocks able to sustain earnings growth even during a slowing economy.
“The US is home to many quality firms – those boasting strong balance sheets and cash flow,” said Moore. “Quality remains a key theme amid uncertainty. Two sectors where we are finding it: healthcare and technology.
“Our preference for emerging markets reflects solid earnings, stimulus in China, improving liquidity, and greater China A-shares inclusion in the MSCI Emerging Markets index.”
Moore and Thiel concluded: “We still see a narrow path ahead for risk assets to move higher – but there are risks that could knock markets off track.”
In its Q2 outlook, BlackRock’s global chief investment strategist Richard Turnill had warned of “creeping complacency” in markets, highlighting several of the risks that could hit markets.
“The global economy needs to be strong enough to avoid sparking recessionary fears – and weak enough to keep policymakers on hold,” he noted. “Any decline in US or global growth expectations would likely roil markets, raising the potential for late-cycle selloffs amid rising recession fears.”
Turnill added: “A hawkish shift in monetary policy expectations, such as the Fed resuming its tightening path sooner than expected, could have a simi