Winds of change amid low visibility

The financial crisis has reduced visibility almost to zero, creating unprecedented volatility. But active managers can profit from the tempest while looking for early signs of recovery.

Market conditions over the past six months or so have been incredibly difficult, and as we move through the first quarter of 2009, they do not seem to have improved. The key problem is the high level of uncertainty because of a lack of visibility about the future. This has in turn created unprecedented volatility among all asset classes.

The crisis in the financial sector, initially thought to be well contained, has spread into the real economy with a vengeance. It has changed people’s perceptions: from ­taking on huge debt and investing in risky assets, they rushed to deleverage at almost any cost because of extreme risk aversion.

This has created a total change in investors’ focus. From worrying about the return on their money, they now worry about the return of their money.

A depression will be avoided, but the slowdown in economic growth will be brutal – we have seen this in economic data over the past few months. Looking at GDP, industrial production, exports and business and consumer confidence, all are at multi-year if not multi-decade lows.

However, the main question is: will the unprecedented stimulus by govern- ments – both monetary, with interest rates falling to near zero in many areas, and fiscal, with money being pumped into economies around the globe – stimulate economic growth?

This is important for financial markets, because they are a discounting mechanism. Equity markets, for example, move three to eight months ahead of a low in the economy, so they tend to be one of the best predictors of an end to recession.

The fourth quarter of 2008 was epitomised by a total collapse in confidence, given the worsening financial crisis and its effect on the real economy. All important asset classes plunged downwards, with the exception of government bonds and the perceived haven currencies of the yen and the Swiss franc.

When looking at sentiment in the equity markets, a useful measure is the Vix – or “fear index” – which looks at the options and the premium that investors are willing to pay to hedge their exposure. Sharp spikes in volatility, as we last saw in 1987, are an indicator that the market is near an important low.

The New York Stock Exchange Composite index, which has slightly fewer than 2,000 stocks, has experienced a record number of new 52-week lows. Most noteworthy is the huge spike we saw in October: over 90% of the index made new 52-week lows. This indicates a broad sell-off, a capitulative action.

October was a climactic low in the markets. Since then, they have continued to weaken but the breadth of the market has improved: another positive sign.

In the bond markets, there has been a flight to safety in the form of government bonds. They were the only
important asset class that moved higher in the October-November period.

Investment grade and high yield securities, or non-government bonds, sold off aggressively.

They recovered composure as government bonds moved higher, but the yield spread between the two remains near record levels, showing a high level of uncertainty.

Finally, looking at the currency markets, we have seen a staggering move in the yen against sterling. The yen appreciated by almost 43%, signifying that the currency carry trade, so popular in the past, has well and truly ended.

Sterling has borne the brunt of the sell-off, principally because of the deteriorating British economic outlook. Sharp interest rate cuts by the Bank of England’s Monetary Policy Committee have also made an impact, causing interest rate differentials to narrow.

This is not an environment in which to make bold statements or aggressive asset allocation calls. Until visibility improves, volatility in the markets will remain high. Neither is it a time to buy and hold.

This is a time to manage portfolios actively and take advantage of extreme moves in the markets.

When they present decent value, that is the time to buy. The main focus is keeping it liquid, diversified and simple.

The Vix index

Depreciation of sterling

Fixed income markets