At the start of September, commentators were warning that the easy money had been made and markets were going to get a little choppier.
Such predictions don’t always turn out to be right, of course, but it is fair to say that markets have become more volatile to the downside this month – with US and global equities down 7% and 6%, respectively.
So what explains this turbulence, and should investors do anything about it?
One explanation is rising real yields. The real yield is the nominal yield minus inflation expectations. In many countries, the real yield is negative. Taking the US as a case in point, the difference between nominal bond yields (0.7%) and inflation expectations (1.6%) gives a negative real yield of -0.9%. Over the past month, real yields have become less negative and this might explain some of the selling pressure in risk assets, such as equities, as well as the weakness in gold.
More crucially, however, is understanding the reason behind the rise in real yields - with some market participants pointing to reduced growth, and hence inflation, expectations. Indeed, Goldman Sachs lowered its 4Q-2020 GDP forecast for the US, having previously downgraded growth expectations for Europe.
There are a few reasons for these reduced growth expectations. First, COVID-19 is rearing its head again in Europe and consequently many countries, including the UK, have imposed additional measures which lower the growth outlook. Second, the likelihood of a vaccine being approved for emergency use before the US Election has been reduced now that the FDA looks to be becoming more stringent in its approval procedure. This possibility was first mentioned by the Washington Post on Wednesday 23 September. Finally, in the US, Democrats and Republicans are at each other’s throats over the replacement of Supreme Court Justice Ginsburg who sadly passed away on Friday 18 September. In such a heated environment, it is less likely there will be an agreement on a further stimulus package.
To conclude, some may have noticed the publication of Professor Goodhart’s and Manoj Pradhan’s latest book in which the co-authors predict an inflation resurgence on the back of changing demographics. This highlights the risk in only owning bonds in the risk-off segment of a balanced portfolio. As a result, and when considered in conjunction with the low-yielding environment, investors may find it prudent to own alternative assets.