Market update – Illiquidity and volatility

"As we move through the next phase of policy responses to an over indebted and slow growing developed world, we have to consider how markets might respond to the withdrawal of QE, particularly in the US. The Fed minutes have started to cover what might prompt the authorities to reduce (or taper) the bond purchase programme and alongside some stronger data this has led to a rise in core bond yields. Whilst we do not expect short term interest rates to rise anytime soon, were growth to pick up and QE to be withdrawn or reduced, there is no doubt that the yield curve would steepen materially from here. The recent bond sell off is probably the first indication of how markets might respond to this environment. What is perhaps more informative is how the non-core bond markets have reacted. In particular the sharp sell-off in emerging market bonds is potentially a foretaste of what is to come if this trend becomes more substantive. Being short government bonds and overweight credit and EM debt feels very consensual, driven by a global search for income in a low yield world, and the move to the exit could very quickly turn into a stampede from what has historically been an illiquid set of assets. Although an improving global growth outlook is not necessarily our central case, the US continues to show signs of improvement, and as we move through the year, we move ever closer to QE withdrawal. Given the recent performance of EM, we think it is only prudent and sensible to start to reduce our large overweight in investment grade credit.

The other hugely volatile asset class recently has been Japanese equities which have retreated from their highs of a couple of weeks ago. We are still at the very early stages of properly understanding the full consequences and impact of “Abenomics”. However, there is no doubt that the authorities mean business, and intend to do whatever it takes to stimulate the economy and the liquidity taps are well and truly open. Although the Yen has stopped weakening for the time being, it is now at a level where Japanese industry is very competitive, particularly against the other Asian economies. We expect there to be a substantial improvement in Japanese profitability and earnings and think the equity market selloff is an opportunity to increase our exposure. As a result we are slightly adding to our Japanese equity position and will look to increase on further market weakness."