Global stock markets over the past few years have exhibited historically low levels of volatility and that some key events that would normally cause at least some short term volatility like elections did not rattle them. Synchronised economic growth through rising corporate earnings and accommodating monetary policy in both the developed and emerging economies have cancelled out other concerns but there are frictions in play that could disrupt the equilibrium such as high equity valuations, changes in monetary policy around interest rates and geo-political tensions.
This lack of volatility may have lulled investors into a false sense of security by risking assets for higher yields or even accepting lower returns than would be common for the risk taken. The significant correction in asset value in February and March may have been the jolt that investors needed to consider the frictions in play. As far as our portfolios are concerned our rebalance in January to higher cash and target return equity was well timed and protected portfolio values relative to the national benchmark averages.
There is some concern that at this late stage in the economic cycle that stock markets are heading for a significant correction. Opinions differ considerably between those that see the economic fundamentals such as raising corporate earnings, low interest rates and lacklustre inflation still supporting global growth to those commentators that fear overvalued stock will be hit by the threat of higher borrowing costs. We continue to take a cautious stance, one that has held up well during recent volatility but without losing out on growth opportunities.
Valuations are high in several asset classes but the fundamentals influencing these values do remain good. Historically, higher than average valuations have led to lower returns rather than prolonged negative returns.
We will remain overweight in cash but we know cash is costly to performance and is only used at times of volatility to protect capital from any potential correction that may or may not occur. An optimistic outlook can be held particularly if inflation in the US is well behaved and US interest rates return to normal along the gradual path the Federal Reserve has signalled. However, with 10 year US treasury stock yields now rising to 3% there is a feeling that inflationary pressure is growing. Any policy error with respect to the curbing of future inflation could however be a catalyst for market falls.
At our next rebalance in June we will redirect some cash holdings to other areas that provide protection but offer the potential for higher returns such as global inflation linked bonds, short duration high yield bonds, property funds and target return equity funds.