Multi-asset allocation views

Read this article to understand:

• The short-term factors behind recent market volatility
• Why the shifting medium-term picture warrants caution
• What this means for multi-asset portfolios

After a relatively calm year, volatility returned with a vengeance in the first week in August. An interest rate rise by the Bank of Japan (BoJ) and a soft US employment report spooked investors, at least temporarily.

The TOPIX index of major Japanese companies fell by over 20 per cent between July 31 and August 5 – the biggest drop in its history – before recovering nearly as much.¹ The VIX index of market volatility also spiked impressively before stabilising by mid-August (see Figure 1).

The key questions for investors are: What has changed? And has it changed enough to require more caution in portfolios?

In the short term, the factors driving the spike in volatility were not a cause for worry and led us to tactically add to some risk positions immediately afterwards. However, medium-term issues have arisen, creating a different set of challenges for multi-asset portfolios.

Short-term causes were overblown…

The immediate drivers of the August market volatility were macroeconomic in nature. The US posted a surprisingly weak monthly employment report and a rise in unemployment, suggesting a shortfall in job creation against expectations.² That led investors to worry about the strength of the US economy and to wonder whether the US Federal Reserve (Fed) had waited too long before cutting interest rates.

In addition, a strong rally in the Japanese yen (up eight per cent in the last three weeks of July) raised concerns that Japanese yen borrowing – or unhedged investment by Japanese investors overseas – might have been a major source of inflows into global markets – a source that could dry up.³

For years, the Japanese currency has had the weakest interest rates among stable currencies, leading Japanese investors to forgo hedging their currency exposure when investing abroad. As a result, a sharp yen rally would significantly reduce their returns in local currency. This would be even more painful for investors, Japanese or international, who had borrowed in yen to invest. The impact on global markets would depend on how many investors had done that, which was unknown – hence the global concern.

On top of this, on July 31, the BoJ increased its benchmark interest rate to 0.25 per cent and stated it would halve the pace of its monthly Japanese government bond purchases.⁴ That contributed to the steep fall in the country’s stock market in the first week in August (see Figure 2).

The good news was that, in each case, there were reasons not to be overly concerned.

Firstly, the US unemployment rate recovered slightly in August, suggesting the July report wasn’t an indicator of a cliff-edge decline in the US labour market.⁵

Secondly, the Japanese stock-market shock was quickly followed by a statement from Kazuo Ueda, the head of the BoJ, stating the bank did not anticipate making further policy adjustments in times of market volatility. That suggested a degree of responsiveness to market conditions meaning the BoJ was willing to slow (but not stop) its interest rate rises.⁶

Shortly afterwards, the Japanese prime minister resigned, which introduced another factor, as the BoJ might not want to create too many waves with its policy in the context of greater political uncertainty, but instead wait until a new administration was in place, to try and understand how the bank might get its support.⁷

These factors offered investors some reassurance the BoJ wouldn’t continue raising rates regardless of volatility.

Thirdly, markets provided their own answer to the concerns about global spillovers, because volatility did not accelerate significantly. It rose sharply in volatility-traded markets like the VIX, but that was an exaggeration of the price action in the corporate sector. Non-Japanese developed market equities did not fall significantly, while the widening in corporate credit spreads wasn’t material and, although there was something of a flight to quality in government bonds, it soon plateaued. For instance, global equities were down by 6.5 per cent in the first week of August, but recovered by the end of the second week and posted further gains during the month and into September (see Figure 3).

In our portfolios, we took the view the immediate market falls were exaggerated and represented an opportunity, particularly with regard to Japan and European equities, allocations to which we added at that time.

…But medium-term trends have shifted

Having said that, there are reasons to be watchful in the coming months, as some things have fundamentally changed from earlier in the year.

Although disinflation seems entrenched, meaning central banks will be able to reduce interest rates if needed, major economies appear to be in a synchronised slowdown. China’s GDP growth has been sluggish all year; the European economy had its biggest slowdown during the second quarter but has not yet posted a strong recovery; and the US is showing signs of a slowdown in certain areas like the labour market.

Moreover, while second-quarter reporting for companies was decent, and has allowed analysts to maintain, rather than cut, full-year earnings estimates for companies in the US and Europe, it did suggest the pace of investment in artificial intelligence (AI) was likely to normalise. In other words, as we head through this year and into 2025, even the major adopters of AI technology like Google and Meta are unlikely to continue investing at the same pace they have done in the past.

We believe AI and other cutting-edge technologies will yield genuine productivity improvements in specific sectors like financial services and healthcare, but also across a range of industries through the application of AI to areas like customer services. However, as more competitors join the fray and start providing additional supply of AI hardware, jostling with the first movers, there is a possibility the overall pace of productivity and profit growth among the leading firms could be slower than expected.⁸

For example, chipmaker Nvidia’s share price was up in the month of August, but when it reported its profits on August 28, which on the face of it beat expectations, the stock still lost 20 per cent over the following days, hitting a low of $102.86 on September 6.⁹ This emphasises the point that strong fundamentals always need to be measured against expectations. There had been signs over the summer those expectations had perhaps run too far, too fast, especially given the natural tailing-off in the pace of investment growth that can be expected over the next 12 to 24 months.

That challenge still hangs over the stock market, particularly in the US and Big Tech. As a result, we have begun to moderate our US exposure.

Investment implications

In portfolios today, we have adopted a more focused approach. There is still enough evidence from corporate reporting and economic demand for a soft landing to remain our central case, but there are also sufficient risks to warrant more selective positions.

Nothing is hinting at a profit recession at this stage, particularly in second-quarter company reporting and guidance, so we continue to favour the US and European equity markets, but we have reduced our positions given the risks.

As discussed earlier, we had taken the opportunity to add to positions in Japanese and European equities following the August sell-off. We still see reasonable value in Europe, but we are more cautious on Japan.

In Europe, the state of household balance sheets is strong, as savings rates have remained much higher than, for example, in the US (see Figure 4). This provides a stable source of funding for European banks and capital markets. And while there is a risk the European Central Bank may keep interest rates higher for slightly longer than the US or UK, we still see reasonable value on offer in the region.

We were surprised by the strong pace of the Japanese equity market’s recovery after the August dip (see Figure 2), bearing in mind the Japanese yen is now stronger than in August and that this will present a headwind to Japanese companies (see Figure 5). Therefore, we are taking a more cautious stance tactically on Japan.

We remain strong believers in the positive structural changes taking place in the Japanese economy, from the move to higher inflation and a more normal monetary policy stance, to improved corporate governance. A more watchful approach is needed, however, from a near-term perspective.

On the other hand, the serial underperformance of emerging markets may now finally see some respite, courtesy of the Chinese authorities. Beijing has for several quarters tried to have its cake and eat it, seeking to arrest sliding economic confidence while casting the economy into a particular shape.

However, the approved profile of high-tech manufacturing and a muted housing market has failed to restore confidence, and baby steps to ease lending conditions are now recognised to be inadequate. As a result, we are seeing a qualitative change in China’s economic policy, combining more aggressive monetary easing with fiscal expansion to support consumption and improve other sectors’ balance sheets. We no longer believe it is appropriate to be underweight emerging markets.

On the fixed income side, markets have rallied since the end of July, through the volatility in August, and have remained at fairly strong levels (see Figure 6). Investors are pricing in a quantity of interest rate reductions, for example in the US, that may seem excessive if the economy stabilises and quickly recovers. But equally, in “harder landing” growth scenarios, those numbers make sense and might be an underestimate. This two-way risk explains the current pricing of bond markets.

With bonds being fairly valued today, the negative relationship between bonds and equities has also reasserted itself.¹⁰ The natural role of bonds as a diversifier for equities is back in play, meaning there are portfolio construction benefits for multi-asset funds in having their full strategic allocations to government bonds.

We also see specific opportunities, for example in the gilt market, which has been a long-term overweight for us. Signs of slowdown in the labour market in the UK are stronger than in most other developed economies, some of which are starting to come through in wage settlements. Meanwhile, in contrast to other economies, past monetary policy tightening is yet to fully affect mortgage rates, and therefore, borrowing in the housing market. As a result, interest rates could come down a little faster in the UK than elsewhere, which represents a favourable outlook for the gilt market.

There are risks; for instance, government issuance of UK gilts has been strong. We take some comfort from the new government stating it will maintain fiscal discipline, as this offers some reassurance of stability, even if it doesn’t mean it will be easy to improve public finances.

Overall, different stories and greater differentiation are starting to come through across markets, and multi-asset investors should remain alert to these shifting trends.