You may have noticed some increased volatility recently, particularly in the Equity sector. We have received the below update which should help to explain this, and why it is a normal part of the investment process/cycle, as well as provide reassurance.

The below is provided by Waverton following their recent asset allocation committee meeting, but is a very useful explanation of what is going on currently within the main asset classes you will be invested in.

Waverton Asset Allocation Committee Update

We see three factors that have coincided and driven the recent elevated volatility:

1. Technical – a significant positioning unwind in the Japanese Yen which has had impacts in other markets. The yen carry trade had worked well in the last 18 months with only minor blips, as the Bank of Japan maintained zero interest rates while other developed market central banks were raising rates. This contributed to a weakening yen which added to the returns for those borrowing in yen to invest in higher yielding assets. The sharp rise in the yen that began in early July accelerated last week and will have created margin calls for those borrowers. This has been a significant contributor to the dramatic falls in some markets, not least the Japanese stock market itself which had its worst day since 19 October 1987 on Monday 5th August.

2. Growth scare – weaker than expected data on the US labour market released on 2nd August added to worries from other recent data such as the August Purchasing Managers’ Survey which suggested the US economy could be beginning to slow more rapidly. This led to a significant repricing of expectations of what the Federal Reserve would do over the balance of this year. A month ago, the market was expecting two 0.25% interest rate cuts between now and the end of the year. Today the market is expecting four cuts including fully pricing at least one cut at (or before) the September 18th policy making meeting. At one point on Monday the yield on 2-year notes was lower than the yield on 10-year notes (i.e. the yield curve by this measure was uninverted) for the first time for two years. Generally, recessions start after a period of inversion ends.

3. Fundamental – global earnings growth is currently running at +11.5% (in £) so far in Q2, the highest rate of growth since Q1 2022. Sales and earnings beats have been smaller than what has become “normal”, however, and the extreme optimism and crowded positioning in large cap tech especially, left this narrow cohort of this years’ winners susceptible to heightened volatility if investor expectations were not met.

Markets repriced aggressively on Monday on the back of the above. However, some things need to be taken into consideration.

• The unwinding of the carry trade has been a key to the extremity of the moves in recent days. It will take time to know whether the moves have created casualties among investment firms that could create more selling.

• The growth scare has been a long time coming but needs to be tempered by the unreliability of US labour market data, particularly when a hurricane hitting Texas and several other states across the US during the period of the data gathering likely negatively impacted the report.

• One of the better indicators of whether a recession is coming is when we see a fall in the ratio of corporate profits to GDP in the national income accounts. One of the strengths of the US economy in recent quarters has been the ongoing robustness in that measure of corporate profitability and we suspect that will have held up in Q2 when that data is released next month.

• It is also important to not get too excited about the flattening of the yield curve between 2-years and 10-years. From an economic perspective, the yield curve spread between 3-month bills and 10-year Treasuries is the more significant. That remains inverted by 1.4%.

We are not minded to change our headline asset allocation. As explained below, retaining a long-term investment perspective is key in this kind of market environment.

Within fixed income we reduced duration on Monday but retain above “normal” duration. We also continue to have credit exposure at the low end of our historic range.

We have rebalanced the Waverton Protection Strategy by taking some profits in our long volatility strategy. We believe hedging is also justified by the potential for heightened tensions in the Middle East as it is possible that Iran could attempt to escalate the conflict with Israel after the successful assassinations of key Iranian backed personnel in recent days.

Equity Views

  • The Equity team’s views are unchanged, and our global equity exposure remains focused on larger cap companies able to deliver future free cashflow growth while also maintaining our valuation discipline.
  • In this type of market environment where volatility is elevated and the speed and pace of market sentiment shifts are exacerbated by systematic and derivatives trading, retaining a long-term investment perspective is absolutely key.
  • We focus on identifying industry leaders from a global (rather than regional) perspective, without making calls on specific markets and/or currencies. Currency moves, even when dramatic, tend to wash out over time.
  • Through this earnings season, results have exceeded expectations at both the top and bottom lines in aggregate. Extended valuations in select parts of the market, heightened expectations for Q2 earnings (especially amongst the AI beneficiaries) and the extreme concentration we have witnessed in markets year-to-date, however, left equity markets susceptible to downside risks, and daily moves in individual names post-earnings release have certainly been exaggerated in both directions this quarter.
  • Add in a dramatic acceleration in the unwinding of the long-standing dollar/yen carry trade after the Bank Of Japan rate increase coincided with the release of weaker than expected US Manufacturing ISM and Nonfarm Payroll data at the end of last week, and markets witnessed a sharp risk-off rotation over the first few days of August. A large part of Japan’s 12.4% market decline on Monday reversed on Tuesday, however, highlighting the speed with which some of these short-term moves unwind.
  • Our bottom-up view is that the fundamental outlook has not meaningfully changed, making this rotation more technical than fundamental in nature and, in our view, negating the need for emergency rate cuts before the next Federal Reserve (the Fed) meeting.
  • The US economy is slowing as companies within select industries have already been alluding to all year. This is consistent not only with what the Fed has been attempting to engineer through higher rates, but also with the normalisation of post-pandemic trends. US employment data has certainly been softening but there are good reasons to question the reliability of the latest print, and unemployment levels overall remain very low by historic standards. Consumer balance sheets remain healthy, as do corporate and, importantly, bank balance sheets.
  • Commentary suggests higher rates are tempering consumer spending (especially in the housing market where pent-up demand remains strong) and delaying some large industrial projects in the near term, with November’s US election adding another element of uncertainty. Consumer-related results to date have again highlighted weakness across the low-income cohort in particular, but also that the growth in travel & entertainment spend is normalising and that consumers more broadly are increasingly price-sensitive.
  • It has been a difficult start to the month for global equity investors, but we remain comfortable with our current positioning. While there is more value on offer than a week ago, it feels like a healthy reset in some areas and we believe markets could remain volatile near term, highly sensitive to individual macro data points with the bulk of earnings results now behind us and with no certainty around how much more of the carry trade unwind there may be to go. Low trading volumes over the summer, potential issues for some investment houses from the carry trade unwind, and escalating tensions in the Middle East all add to the uncertainty.
  • Turnover within the Strategic Equity Fund (WSEF) and Global Equity Fund (WGEF) remains low YTD. Both funds have continued to top up more defensive positions (UNH, TMO) with cash inflows this week and, as ever, the team will continue to use market fluctuations to review both existing holdings for potential upgrades and/or top-ups, as well as new names for potential inclusion.

Fixed Income Views

  • The Sterling Bond Fund (WSBF) is positioned to benefit from a risk-off scenario, something we have been cautioning about for several months. We maintain relatively high durations of 9.4 years, with an average ratings of A. Additionally, we employ several tail-risk hedges to provide convexity in such a scenario, including long bond call options and a put option on the Crossover CDS Index.
  • The recent market moves have been relatively sharp and seem like a short-term overreaction. It is important not to overreact to single data points, as there are several reasons why a soft landing should remain the base case. With interest rates at 5.5%, if a recession begins to materialise, the Fed can cut rates sharply and create significant stimulus, which would act as a powerful backstop.
  • Our cautious view within Fixed Income is driven by two factors:
  • Market complacency regarding the risk of a hard landing. With real rates this restrictive, for this long, we believed a hard landing was a higher probability than was being priced by markets; and
  • valuations on government bonds appeared highly attractive with real yields above 2%, so we were being paid to sit defensively and wait. Meanwhile, credit spreads were historically tight, so we have favoured government bonds.
  • While we do not foresee long-dated bond yields falling below 3% (assuming a neutral Fed funds rate of around 3%), we believe there is still some upside at current real yield levels. We remain bullish even if a soft landing occurs. However, as last week’s data shows, there remains a distinct possibility of an economic slowdown, which could lead to a sharp series of rate cuts by the Fed and significantly lower yields. We want to be positioned to capture this, should it occur.
  • When would we consider reducing duration? We sold some long-bond call options on Monday as we felt the recent moves might be overdone in the short term. That took about 0.5yrs out (most of which had been gained over the last 2 trading days). However, like the Fed, we will remain data-dependent and await a clear turn in the data indicating the negative impact of tight monetary policy is behind us before reducing duration meaningfully. In the meantime, with growing macroeconomic headwinds and falling inflation, we believe our current positioning is well-aligned.
  • The Fund performed well during the risk-off move but have naturally given back some gains as markets have calmed down.

Alternatives Views

  • Prior to the market volatility in August, July was a strong month for Real Assets, with the Waverton Real Assets Fund rising 3.5%, outperforming many major market indices. The Bank of England rate cut towards the end of the month was perceived positively and discounts have started to narrow, however there is a long way to go.
  • Midday NAV pricing versus end of day index pricing can mean it is hard to get an accurate picture on the very latest overall alternative performance. However, MTD performance indicates that Real Assets in aggregate outperformed the wider equity market drawdown but have fallen in absolute terms.
  • Gold has been performing strongly. Gold has set a new all-time high on a weekly close basis as the weak macro data saw US real yields start to fall, supporting the gold price.
  • CTA trend strategies such as Dunn have been weak in this initial reversal. Broadly suffering from long yen positioning and certain long equity positions. Interestingly, Dunn switched from short fixed income exposure to long exposure recently, which helped offset losses elsewhere in the portfolio.
  • Waverton Absolute Return has fallen c.70bps MTD. We have seen some weakness from both structured opportunities and absolute return strategies in aggregate, however the shift lower in short terms rates has benefited the directly invested short-dated specialist fixed income portfolio.
  • Our inclination is to add to certain favoured names in the listed Real Asset space, where valuations continue to look compelling and where central banks are on a rate cutting trajectory, which should benefit many longer duration names such as those in the Fund.

Risk Warning

The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.

Changes in rates of exchange may have an adverse effect on the value, price or income of an investment. Past performance is no guarantee of future results and the value of such investments and their strategies may fall as well as rise. Capital security is not guaranteed. Derivative instruments can be utilised for the management of investment risk and some of these products may be unsuitable for investors. Different instruments involve different levels of exposure to risk.