Thoughts On This Week's Tricky Markets

Over the last two weeks, commentators have been warning about increased “choppiness” in the markets.

This is exactly what is playing out, and there are a few reasons for this.

Reasons for Choppy Markets

Firstly, COVID-19 is not going away and in many countries, it is getting worse. For example, in Spain, Romania and Portugal, ICU hospitalisations are now at their respective peaks that were observed at the beginning of the year. With more lockdowns looming, economists may soon downgrade their growth forecasts.

Secondly, Pfizer reported its quarterly earnings this week. In the run-up to the announcement, there was some optimism amongst investors on its expected vaccine progress update as well as its earnings, however the company disappointed.

Thirdly, the US presidential election race tightened in key swing states. As of the 23rd October, polling aggregators gave the Democratic candidate, Joe Biden, a four-percentage point lead in Florida. Today, that lead has narrowed to just two percentage points, or within the margin of error. This increases the probability of two outcomes that markets view unfavourably: (i) a delayed election outcome, i.e. the election result not being known on the night, and (ii) a contested election.

Finally, according to pre-market trading levels, investors did not respond as favourably as one might have expected to the mega-cap Tech stocks given the mostly excellent earnings results. As of the time of writing, a Bloomberg headline reads “US Futures Drop on Tech Worry.”

Welcome to the So-called Balanced Portfolio

On Wednesday 28th, markets exhibited a mini crash with US equities down some 3.5%. That is quite a lot in one day. Recall that bond yields are supposed to fall – and bond prices to rise – when markets get choppier, thereby dampening volatility in portfolios. This raises two questions:

First, how might have bonds been expected to perform given the 3.5% decline in equities? Based on statistical analysis, bond yields on average have fallen by 6 basis points (0.06%) – and bond prices on average have risen by 1% - on such days.

Second, how did bonds actually perform? Well, US government bonds did exactly nothing. It is also worth noting that US equities are down some 1.6% this month and yet US bond yields are up by 14 basis points (0.14%), i.e. bond prices are down on the month. Welcome to the so-called balanced portfolio.

With this in mind, investors may wish to dampen portfolio volatility by considering alternative investments, i.e. assets which deliver returns that are both negatively correlated to equities and exceed the rate of inflation (or a positive real return). The real return on US government bonds is currently negative.

Looking ahead, as markets are expected to become a little calmer a few weeks after the election and with updates on vaccine progress to be announced in the coming months, the case for holding equities remains intact.‍


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