Global markets have been unusually weak over the first few weeks of the new quarter.
What has happened and why?
US 10-year treasury bond yields have moved up through the psychologically important 3% level, breaking a 30-year downward trend and provoking a c7% drop in the FTSE 100 over the first few weeks of October. The reason such bond yields are important to markets is that they are used to discount the future value of cash flows. All else being equal, higher discount rates lower the present value of future cash flows and hence asset prices.
Which parts of the market have been hit hardest?
Higher discount rates are particularly painful for assets with a long duration (i.e. assets such as long-dated bonds and equities that are set to provide returns far into the future). Within equity markets, popular growth companies have therefore been hit the hardest. Arguably, the assets with the longest duration in the market are the fast-growing US tech stocks. These have led the market up in recent years but generally lack a dividend and sit on expensive ratings that rely on widespread confidence in their future growth. This makes them particularly vulnerable to higher discount rates and so it is no surprise that such companies have led the market down in this instance.
How has this affected client portfolios?
Portfolio values are down but should prove robust compared to the market thanks to a) our short duration strategy in the fixed return part of portfolios, and b) our value bias in the equity part of portfolios, which has kept us underweight the popular growth companies that have been hit hardest.
What is the wider context?
The broader context is that the market volatility of the last 12 months follows a period of strong gains and should prove healthy, provided that the global economy does not suffer a period of disappointing growth or recession. As things stand, global GDP growth has slowed a little from its recent peak but still stands at a robust 4% year on year. Despite the odd hiccup, our firm belief is that global growth will continue to be dragged upwards over the long term through rising populations, continuing innovation and productivity improvements. In turn, equities are the ultimate beneficiary of this growth.
In the meantime, it is important to remember that volatility is no bad thing for long term investors. In particular, it offers the opportunity to take advantage of unusual price swings. Of course, the current market weakness may yet evolve into a more serious downturn – but if it does, history tells us that markets tend to recover fairly quickly. The key to equity investment remains the ability to be calm and stay invested during times of stress. Turning to our portfolios, we find comfort in the fact that the valuation of the UK stock market is not excessive - certainly compared to the relatively expensive US market. In downturns, it is the expensive areas of the market that tend to get hit hardest. Finally, in the fixed return part of portfolios, we remain firmly tilted towards securities with a short duration.
For more information please contact your Wealth Manager, or alternatively call us on 01223 720 208.