MITON’S DAVID JANE: SOUND AND FURY, SIGNIFYING NOTHING

• Markets will remain bumpy as battle between the real world and computers continues
• Concerns should be over permanent capital loss, not daily price swings
• Volatility should be seen as offering up opportunities not a reason to be fearful

David Jane, manager of Miton’s multi-asset fund range, comments:

“Until a couple of weeks ago, the market had been on a consistent upward trend with barely a wobble since the mid part of 2016. In fact, it had gone on for so long that pundits had given up predicting a correction. Now we have had, or maybe remain in, that correction, the headlines have switched to doomsaying.

“The issue that most commentators have argued as the proximate cause for the sell-off is higher than anticipated inflation, leading to rising bond yields. The reason this spooked the markets in such a dramatic way is rather more technical than the headlines suggest. There is a little understood and complex relationship between interest rates, bond yields and the price of volatility.

“As interest rates rise, particularly at the short end, the basic profitability of a number of very popular income generating strategies becomes less and therefore, they are unwound. In essence, as expectations rose for higher inflation, traders expected volatility to rise, and started to buy volatility, which in the very short term became a self-feeding bubble. This led to a total loss for a number of investors who were shorting the volatility. In many ways this is a healthy process as the short volatility, risk parity bubble was irrational all along and had driven a degree of complacency amongst investors.

“In terms of where we are now, it is reasonable to expect volatility to settle at a higher level than before, firstly as we expect higher interest rates as we exit the QE era, but also because the short volatility and risk parity traders now understand better that the trade is not risk free. The implications at this point are unclear as it comes down to the balance between the computers and the real world.

“The computers, driven as they are by algorithms which suggest that higher volatility means higher risk might be sellers of risk assets, from equities through to corporate bonds and even government bonds. In the real world, higher growth and inflation implies a better environment for corporate profits and there is little evidence that the economic cycle is coming to an end, which suggests that equities can continue to make further progress. We would, however, be very cautious on the outlook for government bonds and credit spreads in this environment.

“On balance, we feel a higher level of volatility is a healthy thing; it should throw up more opportunities and does not necessarily make equities a less attractive investment. We are less concerned with the level of daily price swings and more concerned with the potential for permanent capital loss.

“However, we must recognise that an awful lot of money is run in ways which disagrees with this view. There are models which suggest that in times of low volatility more equities should be bought, an approach which led to the sustained rises in markets which recently came to an end with a bump. These investors will now be adjusting their algorithms to take account of higher volatility, a process which may lead them to sell some of their equity.

“Therefore, we would expect markets to remain bumpy as the battle between the real world and the computers may continue for some weeks yet but for a long-term fundamental investor, this should be seen as offering up opportunities not a reason to be fearful. The return of volatility is very long overdue and we welcome it, albeit cautiously.”

• Markets will remain bumpy as battle between the real world and computers continues
• Concerns should be over permanent capital loss, not daily price swings
• Volatility should be seen as offering up opportunities not a reason to be fearful

David Jane, manager of Miton’s multi-asset fund range, comments:

“Until a couple of weeks ago, the market had been on a consistent upward trend with barely a wobble since the mid part of 2016. In fact, it had gone on for so long that pundits had given up predicting a correction. Now we have had, or maybe remain in, that correction, the headlines have switched to doomsaying.

“The issue that most commentators have argued as the proximate cause for the sell-off is higher than anticipated inflation, leading to rising bond yields. The reason this spooked the markets in such a dramatic way is rather more technical than the headlines suggest. There is a little understood and complex relationship between interest rates, bond yields and the price of volatility.

“As interest rates rise, particularly at the short end, the basic profitability of a number of very popular income generating strategies becomes less and therefore, they are unwound. In essence, as expectations rose for higher inflation, traders expected volatility to rise, and started to buy volatility, which in the very short term became a self-feeding bubble. This led to a total loss for a number of investors who were shorting the volatility. In many ways this is a healthy process as the short volatility, risk parity bubble was irrational all along and had driven a degree of complacency amongst investors.

“In terms of where we are now, it is reasonable to expect volatility to settle at a higher level than before, firstly as we expect higher interest rates as we exit the QE era, but also because the short volatility and risk parity traders now understand better that the trade is not risk free. The implications at this point are unclear as it comes down to the balance between the computers and the real world.

“The computers, driven as they are by algorithms which suggest that higher volatility means higher risk might be sellers of risk assets, from equities through to corporate bonds and even government bonds. In the real world, higher growth and inflation implies a better environment for corporate profits and there is little evidence that the economic cycle is coming to an end, which suggests that equities can continue to make further progress. We would, however, be very cautious on the outlook for government bonds and credit spreads in this environment.

“On balance, we feel a higher level of volatility is a healthy thing; it should throw up more opportunities and does not necessarily make equities a less attractive investment. We are less concerned with the level of daily price swings and more concerned with the potential for permanent capital loss.

“However, we must recognise that an awful lot of money is run in ways which disagrees with this view. There are models which suggest that in times of low volatility more equities should be bought, an approach which led to the sustained rises in markets which recently came to an end with a bump. These investors will now be adjusting their algorithms to take account of higher volatility, a process which may lead them to sell some of their equity.

“Therefore, we would expect markets to remain bumpy as the battle between the real world and the computers may continue for some weeks yet but for a long-term fundamental investor, this should be seen as offering up opportunities not a reason to be fearful. The return of volatility is very long overdue and we welcome it, albeit cautiously.”