A bit of volatility

Why so volatile?

Friday, August 30th 2024, 2:53PM

by Octagon Asset Management

It would be hard to have missed the dramatic move in various asset classes over the last month or so. The Japanese yen fell to its lowest level against the US dollar since 1986, then rose over 10% in just four weeks. Nvidia, briefly the world’s largest company, fell 21% over the same period. The US government 10-year bond interest rate fell from 4.2% to 3.8%, before rising back to 4%. While that is only 0.4%, it’s a big move by bond market standards.

Markets absorb new information every day. And an investment manager is always looking to discern what are true ‘market signals’ from the vast amounts of ‘market noise’. The biggest periods of volatility usually come about when market participants believe that the current situation is going to change dramatically. Right now, this expectation of dramatic change exists across multiple asset classes - currencies, interest rates and equities.

What happened and why so fast?

In currency markets, Japan is raising its interest rates while most of the rest of the world is cutting or preparing to cut. One of the drivers of currencies is the interest rate difference between them – if an economy is strong enough to cope with high interest rates, it often sees its currency strengthen as investors seek out that attractive combination. But this interest rate rise had the effect of making the popular carry trade – borrowing cheap Japanese yen to invest in other markets’ growth assets – less profitable. Thes positions were quickly and dramatically unwound with the rise in interest rates announced by the Bank of Japan.

For Nvidia, a leader in the Artificial Intelligence (AI) space, markets are asking whether its share price has gotten ahead of its underlying earnings. Billions of dollars are being spent, but the productivity gains and new products and services that AI is meant to drive haven’t really shown up yet. This is not unusual, the internet age started with the personal computer in the 1980’s, but it was 10 years before new ways of doing things were widely adopted.

For US interest rates, there are increasing signs that economic growth may be slowing faster than the consensus view. The current view is a ‘Goldilocks’ scenario where inflation and the economy slow but employment and profits remain robust. In a recession scenario, the US central bank will have to cut interest rates aggressively to stop a downward spiral and markets are anticipating that this is a likely outcome.

Nothing in markets happens in isolation. More money flowing back into Japan means less investment in growth assets in other markets. Lower growth in AI-related spend would hurt the performance of the narrow group of tech stocks known as the Magnificent 7 and slower economic growth in the US would see profit expectations fall.

That’s not to mention political volatility that has seen an attempted assassination of a US presidential candidate; an Israeli strike on Iran or a turn in the Ukraine war that has seen attacks by the Ukraine army on Russian soil.

Long-term fundamentals coupled with short-term agility

An experienced asset manager looks through this short-term volatility. Not least because experienced portfolio managers will have seen it all before; that is why experience counts in investment management as it brings perspective. As they say, history may not repeat, but it sure does rhyme!

Using short-term volatility to your advantage means having an fundamental view of the long-term value of each asset class, but reacting to short term market moves and price disruptions that are unlikely to be sustained for the benefit of your client.

The dramatic move in interest rates markets saw investment managers, including Octagon, lower its exposure to fixed interest markets in favour of the listed property sector. As interest rates fall, the rental streams from property leases, as bond proxies, become more attractive. It is just one example of active managers look to maximise investor returns.

As long-term investors we want to keep our exposure to assets with attractive return and risk characteristics over time. The economy and investment markets move in cycles – sometimes during those cycles markets price an asset too cheaply or too expensively compared to its long-term value. We don’t react to every piece of information, and we only change our short-term view where there is a strong signal within the noise.

Tags: Octagon