Volatility is here to stay, so investors should get used to it. Events in Greece and China have given us plenty to think about in the near term and, beyond that, there is the momentous prospect of the first rise in US policy rates since 2006. When we consider some of the key issues for investors, the following three themes are most important.
Prepare for instability
European bonds recently delivered a useful reminder to investors that fixed income markets are not a one-way bet.
Speculative investors lost a lot of money on German sovereign bonds in May and June, in a series of sell-offs that saw decades’ worth of income destroyed in a matter of days. But it was actually a healthy correction. The downward move in yields (especially at higher maturities) in the first part of the year was extreme by historical standards, taking them much lower than could be justified even by Europe’s very low inflation and loose monetary policy.
Last quarter’s dramatic sell-off led many to question whether the long rally in European bond markets was over. It would be good news for Europe’s economy if core yields were now past their lowest point for this cycle but we should remember a significant amount of sovereign debt still carries a negative yield and 55 per cent of the eurozone government bond market yields lower than 1 per cent.
We have seen volatility pick up on both sides of the Atlantic in recent months but equity markets in Europe have so far been much more affected than in the US. That is no surprise, as the uncertainty in the US is focused more on the Federal Reserve and the implications of higher interest rates for fixed income assets.
With policy rates going up this year in the US and the Bank of England not far behind, volatility in bond markets may only intensify. When the going gets tough, it is more important than ever for investors to be diversified.
Trust in Europe
The good news we saw coming out of Europe in the first part of the year has continued into the summer, despite the volatility in markets and the question marks about growth in the US. This is an encouraging contrast with 2014, when a nascent first-quarter recovery had stalled by the end of the second.
Stronger domestic demand and European earnings forecasts being revised up should be good news for investors in European equities over the medium term. Considering the recent sell-offs there may also be more opportunities for investors to find value than a few months ago. However, it is important to consider which sectors and companies are going to benefit most from the recovery. We would also highlight that corporate investment has yet to play its part in growth.
US equities: a matter of measure
The US equity market faced headwinds in the first part of the year, as companies absorbed the negative effects of both the stronger dollar and lower profits in the energy sector, without any offsetting positives for domestic consumption due to cheaper oil. Oil and lower foreign earnings between them accounted for most of the slowdown in corporate profit growth in the first quarter.
We believe these short-term negatives will abate in the coming months but many investors in US equities are sceptical of further gains, pointing to lofty valuations as a sign of imminent correction.
Certainly the market’s current valuation is slightly above its long-run average but valuations can remain above average for long periods of time. The Fed’s impending move away from zero-rate policy should be interpreted as the all-clear on a healthier economy and signal an environment in which companies can deliver earnings targets and push markets higher.
Valuations in and of themselves are not the best tools for predicting the timing of a bear market. Looking at the 10 bear markets that have occurred in the US since 1926, steep corrections tend to be external to equities, such as recessions, wars and credit bubbles.
But, of course, valuations do matter for investors because they determine the return you are likely to receive in the long run. Pay a high price and you are likely to earn less in the future. This underlines a broader message for investors as we look to the second half of 2015 and beyond: diversify more and expect less.
Stephanie Flanders is chief market strategist for UK & Europe at J.P. Morgan Asset Management