Simon Ho

The global economic outlook is looking increasingly uncertain, with volatility set to re-appear, but opportunities exist for shrewd investors who understand the global backdrop and risks, and who do their research, says investment experts with Grant Samuel Funds Management.

Volatility is on its way and all the signs are indicating it will be with us sooner rather than later, says Simon Ho, chief investment officer of Triple3 Partners.

“There are multiple threats casting clouds over the global economy,” he says.

“We have trade wars which, if they play out, will wreak havoc on global economic growth, along with rising interest rates as stimulus unwinds in the US, Europe and Japan.

“Meanwhile, falling unemployment is exponentially increasing the inflation risk in the US.

“Throw in the oil market disruption as Iran threatens to block the Hormuz strait, to a mix of already expensive assets thanks to 10 years of unabated asset prices rises, and it is clear the threat to global economic prosperity is real.

“However withdrawing from equity markets is not the answer, as over the long run they tend to do well. Instead, with volatility looming, investors should position their portfolios to protect against a market downturn. For instance, using options over the VIX can help mitigate portfolio losses when equity markets fall,” Mr Ho says.

Stephen Miller, adviser with Grant Samuel Funds Management, also points to the increased threat of inflation in the US, with key indicators pointing to a marked acceleration in inflation.

“The Underlying Inflation Gauge (UIG) – a market measure which adds financial market information into the CPI to provide a more accurate picture – suggests that there is more inflation to come in the US, and there is a very real prospect of inflation noticeably exceeding the Federal Reserve’s ‘soft target’ of two percent.

“The Fed has recently indicated it is somewhat relaxed about this eventuality, but the extent of that relaxation may still mean four policy rate hikes of 25 basis points (bps) each in 2018.

“Nevertheless, the US budget deficit is projected to be close to 5 per cent of GDP in FY2019. With the US at full employment, demand could well spill over to imports and higher inflation,” he says.

This has implications for equity and bond markets, and Mr Miller says arguably, the outlook for both equity and bond beta is challenging.

“At the margin bond investors need to contemplate portfolios that are more flexible and access diverse sources of risk and not be tied to durations of particular indices. Obtaining beta exposure through say, an ETF, may not be sufficient going forward.

“Similarly, equity investors at the margin need to contemplate portfolios that can benefit from stock-picking acumen or the ability to offset long exposures with short exposures and so reduce exposure to equity beta.

“That markets may discount the eventuality of poorly performed bond and equity beta argues for moving sooner rather than later,” Mr Miller says.

Nick Griffin, chief investment officer with Munro Partners, agrees that the uncertain global economic environment will impact growth in the market, but there are still a number of sectors that show promise.

“We have identified several areas of interest, where we expect to see market growth,” he says.

“The top five are digital enterprise, internet disruption, digital payments, e-commence and emerging consumer and our holding in these sectors ranges from 6-12 per cent.”

Taking the example of digital disruption, Mr Griffin says it is accelerating at a fast rate.

“The rise of digital advertising, mobile advertising, social media and video streaming has fragmented the traditional media landscape. It has provided structural growth opportunities for the likes of online platforms, premium content providers and product placement beneficiaries at the expense of traditional advertising businesses.

“To provide some context, within a US advertising market of around $210 billion, we have seen digital advertising grow to $80 billion – an almost 40 per cent share. This share has been growing at 15 per cent per year since 2013.

“Consumers are changing the way they process information and are changing the way they access information and this trend will continue.

“With digital continuing to take share from traditional advertising, network effects are such that the advertising spending flows to the dominant digital platforms, such as Facebook and Google. And with digital channels making up only 22 per cent of global ad budgets, there is still room to grow.”

He says the winners from this movement will be the likes of Google, Facebook, Netflix, Alibaba and Amazon, among others.

Locally, Tribeca Investment Partners portfolio manager, Sean Fenton, says the Australian market will inevitably be impacted by global developments.

“We have become more cautious on the global risk environment,” he says.

“Domestically, there is stronger evidence that the housing cycle has peaked and this is likely to be reinforced by APRA’s efforts to rein in aggressive mortgage lending. This is being magnified by a renewed focus on responsible standards coming out of the Royal Commission and we are already seeing weakness in house prices.

“Further downside risk to the economy may emerge if the current tightening in mortgage lending standards pushes house prices lower and generates negative equity effects. State governments are effectively recycling stamp duty revenue into road and rail infrastructure which will provide some offset to weaker household consumption and the stronger terms of trade is also providing a cushion to national income.

“In terms of portfolio positioning, we have moved further underweight quality growth sectors as valuations push out to extreme levels.

“Domestically, we are positioned towards metals and new energy materials over bulk commodities within the resources sector and we are positioned more defensively in gaming and select industrials. We have increased the underweight to building materials, property developers and retail as the housing cycle rolls over.

“Globally, we are comfortable with the US growth profile and maintain overweight positions to US cyclicals and the cyclical recovery in Europe,” Mr Fenton says.

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Simon Ho

The idea that market volatility is bad and something that investors need to protect themselves against, is outdated and needs to be challenged, says Simon Ho, chief investment officer of Triple3 Partners.

“There are some persistent myths around volatility that endure regardless of markets and trends. By busting these myths, and understanding the true nature of volatility and its impact, investors can benefit from real and sustained portfolio diversification,” Mr Ho says.

The five most common volatility myths include:

1. The market has been very volatile in recent years

“Probably one of the most persistent volatility myths of recent times is that markets have been volatile and that investors need to be cautious,” Mr Ho says.

“In fact, the VIX index shows the recent period since 2015 has been the most non volatile periods of the market’s history.”

The VIX Index is a measure of expected volatility on the S&P500 Index over the next 30 days. High VIX readings mean investors see significant risk that the market will move sharply, either up or down.

“Tracking a synthetic VIX index that has been created to track back to 1928, we find that market volatility is in fact at 100 year lows. The VIX is at 9, which is unprecedented, it has never been lower. There hasn’t really been a less volatile period since the S&P began.

“Investors suffer from recency bias and media headlines do not help. While there have been volatility spikes – market movements on the back of unexpected developments such as Brexit or Trump – there has not been an ongoing period of volatility in the market beyond spikes of a few hours, or at most, a few days, during the past few years,” Mr Ho said.

2. Volatility is bad for investor portfolio

“Far from being bad for a portfolio, volatility can in fact enhance portfolio returns.

“There is no question that market volatility and falling shares prices can be bad for long-only investors over the short term.”
But volatility as an asset class is a different consideration.

“Volatility has emerged as a distinct asset class in recent years that offers a largely untapped source of alpha that can offset losses in the underlying portfolio.

“As an asset class volatility is good for a portfolio in that it is highly negatively correlated to equities. It can be accessed through the VIX Index with the use of options and volatility derivatives and it affords an investor protection in downturns.

“The average investor is long on shares and not many short the market. Market volatility creates opportunities for investors who short the market, and who make a call on which shares will fall in value – as well as which shares will increase.”

3. High volatility equals negative returns

“With the advent of VIX futures options and exchange traded products, high volatility does not necessarily mean a negative return for investors,” says Mr Ho.

“The level of volatility tends to be negatively correlated to equity indices, indicating that when equity markets fall, volatility tends to rise and vice versa.

“Options on the VIX Index allow investors to access this feature, which cannot be as reliably harnessed in other asset classes, making VIX an ideally suited instrument for targeting returns that are negatively correlated to the S&P500.”

4. Volatility is a good reason to stay out of the marke

Mr Ho says volatility actually represents a great opportunity to generate alpha in the VIX futures and options market.

“The VIX was a brand new product in 2004. VIX options have been one of the fastest growing option markets since then, and these days it is one of the most liquidly traded listed derivatives in the world.

“VIX today is front and centre of the conversation in major markets around the world and volatility options are in fact driving investors into the market. Interestingly it is retail usage of these products – particularly exchange traded products – that has driven this seismic growth.

“The most popular ETP in the US and one of the top 5 most liquidly traded securities is the VXX, which is a VIX options based product.”

5. Volatile markets mean a bubble is forming

“The exact opposite of this statement is true. Volatility is usually associated with a piercing of the bubble as opposed to a harbinger of the bubble. Non volatile markets – such as what we are experiencing now – are more likely to indicate a bubble is forming.

“For instance, while there is no volatility in the share market, definite bubbles are forming in bond markets and with house prices.”

Debunking these five common myths would help investors better understand the true impact of volatility on their portfolios, and the opportunities it can create to generate long-term returns, Mr Ho says.

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