- Central banks keep repressing volatility and remain the main market driver
- Equities at historical high and boldly valued, very sensitive to negative surprises
- Optimism outweighs economic weakness, political and geopolitical risks
Back in the comfort zone
The extent to which central banks' activism is decisive for rising markets is best illustrated by a performance comparison between the 4th quarters of 2018 and 2019. At that time, the focus was on the normalization of monetary policy. The financial markets reacted to the news of rising interest rates and balance sheet contractions with an increase in volatility and the sharpest correction in the last ten years. In the first month of 2019, the policy quickly reverted to normal or rather abnormal: balance sheets expanded, interest rates were pushed further down. In the fourth quarter of 2019, volatility fell back to a historic low and the equity indices reached one historic high after another. We are back in the comfort zone under the reassuring, protective shield of the central banks. Basically, we have no objections to this situation at all. In fact, until the end of December, investors were rewarded with one of the best annual returns in the last ten years.
Priced for perfection
It is true that earnings in Q4 and throughout 2019 met expectations, but the expansion of valuation multiples was one of the largest in the last 30 years and a key driver of equity performance. The expectations implied in valuations (high earnings growth and low credit spread) remain high. Interest rates rose slightly during Q4, but remain at historically low levels worldwide. This means that central banks still do not have as much dry powder on hand. Risk measures are at a historical low. The market seems to be priced for perfection, in the sense that there is no room for negative surprises. Any disappointment could trigger a substantial market reaction. In fact, economic data does not yet show the expected acceleration that the market valuation anticipated. Despite the recent conciliatory tone, the US-China confrontation is still there. The escalation spiral in the conflict between the USA and Iran is spinning ever faster - with an unknown outcome. Brexit will materialize over time. It won’t be a Hard Brexit, nevertheless the impact on the economy and markets is not clear yet. Stability definitely looks different.
In defense of risk management
By dealing with what might go wrong, we do not want to play the role of Cassandra and anticipate tragedies. Our task is not to be optimistic, but to look at the market dynamics with the necessary distance. In particular, we want to stress that a stock market year like 2019 does not really correspond to the standard. All our equity strategies have delivered a positive return in the last quarter, highlighting a very positive year. Bond funds have performed negatively due to the slight rise in interest rates. Compared to the respective benchmark, the underperformance over the quarter was strong, almost as spectacular as the outperformance recorded in the 4th quarter of 2018. The historically low risk measure of the last quarter explains the underperformance.
However, low market volatility should not be confused with a risk-free market. Usually the opposite is the case. Some prominent investors also noted that the current high-flying mood is on thin ice and are putting everything on one card, namely "market correction". To be clear, we are not forecasting the end of the bull market, nor do we want to make high bets. As a matter of fact central banks can support the markets for years. Instead of making forecasts in this regard, we continue to focus on building efficient long-term portfolios by consistently addressing the risk dimension. A portfolio geared solely to maximize expected returns would certainly have performed substantially better in the exceptional year 2019. In our opinion, this is no reason to deviate from the fundamental principles of investment, risk management and portfolio construction in the future either.