Volatility Risk Rises on Diverging Outlook

  • By John Taylor, Portfolio Manager―Fixed Income, AllianceBernstein

The volatility that skewered global markets at the start of the year was largely absent during the quarter just ended but may rear its ugly head again soon enough, judging by the number of risks now coming to fruition.

Risk assets, including corporate bonds, are likely to be in the firing line. The good news for banks is that, from the point of view of bond buyers concerned about fundamentals, their liabilities appear to be relatively attractive.

Overall, however, fixed-income investors may wish to be selective about the risks they own. Keeping overall duration low while holding inflation-linked bonds and high-quality, short-dated credit arguably makes a lot of sense in this environment.

The more colourful market hazards are familiar enough: the US-China trade war, Brexit, political instability in the European periphery, and China’s highly leveraged economy. Individually and collectively, they are all potential sources of volatility.

And they are becoming more dangerous by the day. Last week’s resignations of senior UK cabinet ministers over Brexit, which have left Prime Minister Theresa May even more politically exposed than she had been, are the most recent example.

But markets are also confronting a more fundamental anxiety: what if the largely positive global economic outlook that prevailed in late 2017 and early 2018 proves to be short-lived? What if the next slowdown is closer than we think?

The base case at the turn of the year was reasonably clear-cut. Positive economic data suggested that the lingering after-effects of the financial crisis were finally subsiding and that central banks could begin normalising monetary policy to contain upward pressure on inflation.

Hopes dashed

While this scenario contained risks, it was essentially one in which cyclical factors reasserted themselves, and the world would return to something resembling normal. Since the start of the year, however, fresh developments have begun to challenge this outlook.

European economic data has disappointed on the downside, 10-year US Treasury yields have spiked briefly through 3% on rate-rise concerns, the US dollar has risen and emerging markets have been battered by outflows. The economic outlook has quickly become less assured.

The focus has shifted from a cyclical recovery to the possibility that structural factors―for example, high levels of global debt, low productivity growth and ageing demographics―will prevail. One way to test this hypothesis is to measure the effect of tighter monetary policy on economic growth.

China appears to have done this: after tightening financial conditions for two years as part of its deleveraging campaign, it’s now eased again―a reflection not only of risks created by trade conflict with the US, but also concerns about the domestic economic slowdown that may be underway.

If indeed the outlook for growth is less robust than it seemed six months or so ago, then the market risks with which we are already familiar appear even more threatening. The chances of a US-China trade war embroiling Asia-Pacific and the rest of the world, for example, become more acute.

The issue of a hard versus soft Brexit may become a second-order priority for Theresa May, if a deteriorating growth outlook worsens her political position and enlivens the prospects for Jeremy Corbyn to come to power―to the detriment of the UK gilts market and the value of the pound.

Australia is likely to feel the effects, especially as China contends with both a trade war and slower domestic growth. But whether the outlook is for higher or lower global growth, moderate or high inflation, looser or tighter policy, one thing―further market volatility―seems to be a near certainty.