Schroders’ Jolly cautious on expected global bond and currency volatility

6th August 2013

Market volatility is expected to remain high in the next few months says Schroders’ head of global macro Bob Jolly with the fund manager moving to what it says is a cautious stance.

In a note issued this week, Jolly says he is remaining vigilant for mispriced investment opportunities to exploit when markets overshoot in either direction.

Jolly suggests that for the rest of 2013, the US should continue to slowly accelerate and exit so-called ‘stall-speed’ growth.

“Banks have been loosening their credit standards, companies are increasing their capital expenditure and the house prices are starting to accelerate. There has already been a shift in the Federal Reserve’s thinking due to the gradual economic improvements – away from Quantitative Easing and towards tapering – and this has caused a great deal of market volatility.”

The note is less positive about China. “The data suggests that economic activity resulted in an investment splurge following the credit crisis of 2008, leading to over-investment across sectors such as infrastructure and export companies. This has resulted in overcapacity. This over-investment was funded by debt, resulting in rising levels of household and corporate debt. Indeed, data suggests Chinese households have never been so indebted.

“However, much of this has been priced into market valuations so we are not too negative on China from an investment perspective. In addition, the government is making the longer term outlook more promising by putting its emphasis on encouraging quality of economic growth, rather than quantity by enacting policies that focus on moving the economy from being export-driven to a more consumption-based model.”

Jolly remains concerned about Europe’s situation and says in some respects the situation is worsening.

“Bank lending is contracting, the output gap has continued to grow and, with inflation falling sharply, it appears the European Central Bank has not been aggressive enough. The eurozone is already closer to deflation than many believe and tax increases (particularly duty and VAT) have been disguising underlying disinflationary pressures.”

Jolly says that if you exclude taxes from its headline inflation rate, the country is already seeing disinflation.

“Adding to the uncertain outlook for the eurozone is the upcoming German election in September, political posturing in the run-up to which could be an additional source of market volatility”.

In the UK despite moves to kick start the housing market and an improving economy Jolly says it is too early to become optimistic because inflation has acted as a tax on incomes resulting in falling real incomes for the UK population.

In terms of its portfolios, the note says: “In our portfolios we will be closely watching market volatility that is likely to ebb and flow around expectations of central bank actions. Following recent market falls we have been seeking to add to positions which have become less crowded, but we are not adding aggressively to risk markets. The key in such an environment is to be nimble. On the duration front, for example, we expect market noise to cause movements in government bond yields and present opportunities on both the long and short side.”

“Currently we have a neutral duration stance. However, we have been buying some duration at the front end of the yield curve in Europe as we think the market has priced in rate hikes that are unlikely to happen given the economic outlook for the eurozone. Meanwhile we have a short exposure to 10-year US Treasuries as we think the US economy will continue to improve and yields could grind higher.”

On a country basis, Jolly says his portfolios have zero exposure to peripheral eurozone sovereign bonds after it took profits from its Portuguese and Irish positions earlier in the quarter.

“Valuations in the credit market do not look particularly attractive compared to history. However, regardless of Fed tapering, we are in an environment of abundant liquidity, low interest rates, and there is little prospect of inflation in the near future given the size of output gaps. As a result, cash is unlikely to appeal to investors and credit markets will continue to be underpinned by the hunt for yield. We continue to follow a thematic approach to help identify the most attractive credits. In a difficult overall environment for credit, we think prudent credit selection backed up by rigorous research will be rewarded.”

The firm is short on the Japanese yen and the Chinese renminbi and is no longer short the Australian dollar. It is long the Indian rupee and the Russian ruble.

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