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What is a transition environment?
Tapan Datta, global head of asset allocation
For some time now, we have regarded market conditions to signal a ‘transi- tion’ environment. Our timing indicators suggested that we moved into a tran- sition phase sometime in the first half of 2018, taking us from a long period of risky asset strength towards an eventual market downturn phase when bonds will be the only performing asset.
A question we are often asked given the length of the current bull market1 is
when will the ultimate market downturn arrive. A large market downturn still does not appear imminent but sometime within the next year or at most two,
looks a reasonable expectation for such an event – by the summer/autumn of 2020 we estimate we’ll have been in a transition environment for some two-and-a-half years. In this environment, markets will go through several mini-cycles. Volatility will go higher in a jumpy, dis- crete process that essentially reflects the higher level of economic and market uncertainty. It is not necessarily the case that these asset moves are synchronised in the transition phase; only in the final market large draw-down phase are there sympathetic moves in risky assets across the board. Market leadership at sector and stock level can change drastically, though this is not a given. Three main factors will determine the likelihood and scale of such shifts: Valuation anomalies, economic conditions and policy reactions.
Market phasing Market cycle measurement typically focuses only on rising and falling risky asset performance centred on equities. This does not recognise the intermediate or transition phase we are referring to here when risky assets start to perform less well. Typically, transition markets see a tussle between factors pushing markets higher, and those which are pulling markets lower. Down markets should be seen as the end of a process which is set in motion in transition environments. It is what happens in the transition phase that ushers in the final market phase of sharp falls in risky asset prices and outperformance of defensive assets.
Triggers for the beginning of the transition We are in an environment where the longevity of the global business expansion that began 2009 is now looking suspect. US policy interest rates have risen, broad financial conditions are tightening, and expansionary fiscal policy is likely to create added strain at a time when US labour markets are tight and expansion capacity is limited. At the same time, global threats to the economic expansion are rising, given more trade protectionism and growing economic divergence between the US and other regions. The economic risks from this are seen in a flattening US yield curve. Notwithstanding their setback through the end of 2018, equity markets and risky assets in general remain on rougher ground given the change in monetary conditions and narrow risk premiums. Low long duration bond yields still provide some support to equities, but high valuations look less sustainable given the broader economic message from low bond yields and poor economic data.
Triggers for the end of the transition
The transition phase ends as a logical culmination of the changes that are occurring through time. How- ever, a ‘shock’ of some kind is probably needed. This shock could come from some economic develop- ment – a significant rise in inflation which brings concerns of faster-than-expected monetary tightening, or a major economic growth slowdown that comes from either the lagged effect of higher interest rates or the creeping effects of trade protectionism. 1) The current period of rising markets has now caught up with the previous longest, the decade long 1990s rise in markets.
22 April 2019 portfolio institutional roundtable: Managing volatility
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