Risk aversion blamed for volatility

A report released last week by Capital Economics, an economic consultancy, concludes that the inflation- based theories surrounding the recent downturns in global stockmarkets lack credibility.

The report by Simon Hayley, entitled “Taking stock of recent market volatility”, says the main factor behind the selling is a general rise in investor risk aversion, from levels that were unjustifiably low.

The report says that, while the fear of higher inflation was a trigger, bond yields have fallen slightly, indicating a lack of market concern on interest rate rises. Similarly, it says, it is hard to square the fear of slower American growth with the relative stability of the country’s markets, compared with other developed markets.

Toby Vaughan, assistant strategist with F&C’s asset allocation team, agrees that there are several reasons behind the volatility.

“People have been talking about inflation, but it is not the only issue at play,” says Vaughan. “The scale, speed and severity of the volatility suggests it is not down to one figure.”

Vaughan also subscribes to the risk-aversion theory. “There has been a lot of profit-taking by the more liquid money, hedge funds and so on,” he says.

“The market has been reassessed and we have seen a general reversal of the risk trend.

“People have been in a Goldilocks environment, where it was not too hot and not too cold. We do not think it is the start of a huge bear market, but volatility is likely to rise going forward.”

The report is similarly positive on the general outlook for the markets, predicting that the volatility will be seen as “an unpleasant wobble, not a disaster”.

Capital Economics also concludes that the fluctuations have reminded investors of the need for a spread of asset classes.

But, it adds, the increased correlation seen between the classes is undermining faith in the benefits of diversification. In turn, this has reduced investor appetite for “risky” investments, such as commodities and hedge funds.

Finally, the report argues that even if a “global meltdown” is avoided, the fluctuations have not changed the outlook for global markets.

The biggest risk, it says, is that slowing American growth will undermine US equities and the dollar. It will result in weakening emerging market equities and already overvalued oil and other commodities.

Vaughan says inflation is the main concern in the short term, with fears that the Federal Reserve will continue to raise interest rates. Emerging markets are likely to suffer the most, and F&C has recently increased its exposure to American stocks.

“We held a short position in American equities, but are now more positive,” he says. “The US is historically a defensive equity market and we expect it to outperform going forward.”