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March 25, 2016 at 09:59 AM
Risk assets such as stocks, corporate bonds and bank loans have been trading in a wide and volatile range, taking investors on a roller-coaster ride up and down, including most recently a rally of about 10 percent in U.S. equity markets.
This phenomenon is likely to continue in the short-term, so here are eight characteristics of this financial environment:
1. Pronounced fluctuations within the trading range reflect primarily the tug of war between a weakening global economy and continuing liquidity injections from central banks and corporate balance sheets.
2. The fluctuations are accentuated by patchy market liquidity: On the way up, prices overshoot levels warranted by the exceptional funding that markets obtain. That backing includes the monetary stimulus programs of central banks (notably the Bank of Japan, the European Central Bank and the People’s Bank of China), as well as the deployment of corporate cash for share repurchases, higher dividend payouts and mergers and acquisitions. On the way down, prices fall below what would otherwise prevail on the basis of fundamentals.
3. This behavior is likely to continue in the short-term, shifting the opportunities for higher monthly/quarterly returns away from conventional strategic long-term portfolio positioning and toward more short-term trading and volatility trades.
4. Because today’s markets are heavily influenced by the direct and indirect involvement of central banks, correlations among asset classes are less reliable, weakening the effectiveness of risk mitigation through traditional portfolio diversification. Although it remains necessary, such diversification is no longer sufficient to ensure effective risk management. Accordingly, fluctuating cash levels not only provide agility for tactical positioning but also act as a risk mitigator.
5. Over time, the trading range is more likely to get wider than smaller. As this occurs, the probability of either a policy mistake or a market accident will increase. And even absent these two disruptive developments, the range itself will become increasingly fragile as its gets wider.
