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Getting a tad cloudier

On both sides of the Atlantic, policy uncertainty has rarely been as high. Not that you would know by looking at financial-market volatility.

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Editorial

Getting a tad cloudier

Financial markets have been unusually sure-footed, following last year’s electoral surprises and ahead of further political risks such as the French elections. This curious fact has not escaped the attention of some of the world’s leading central bankers.

As the Bank of England noted in its recent Financial Policy Committee statement, “the high degree of uncertainty in many advanced economies appears not to be fully reflected in asset prices (…) or in measures of market volatility, which remain subdued.”

Tactical management remains critical

Measures of implied equity-market volatility indeed remain low, despite occasional, temporary rebounds. Meanwhile, valuations, especially in the U.S., still look stretched and investor positioning not particularly cautious.

Against this background, two questions arise. The simpler one is how to position our multi-asset portfolios. Volatility remains at historically low levels, still offering opportunities for long-dated derivative trades to benefit from tail events being underpriced. Our forecasts reflect an only muted total-return outlook for many asset classes. While macro data have been quite positive lately, economic surprise indicators show early signs of expectations having run too far. On a twelve-month horizon, we only see mid-single-digit gains from current levels for equities, for example. Directionally, we are looking to reduce overall risk over the course of the quarter.

However, this does not imply scaling back risk right away. Instead, we are looking to trade contrarian to make tactical adjustments. Continuing market strength would make some kind of limited correction even more likely. We would react to such a correction by buying into the dips. Europe, in particular, might prove well positioned if and when political risks fade further.

Timing such things is always tricky, of course. This takes us to the second, tougher question, which concerns the longer-term outlook for volatility.

Relatively calm – for now

When you look at actually realized volatility in equity markets and related segments, there has been a clear downward trend in recent years. One plausible explanation for this is monetary policy. Investors have grown used to central-bank activism in the face of market tantrums. This resulted in historically low yields and high equity-market valuations – which necessarily reduces return potential going forward. As the Fed started to increase rates, volatility in fixed-income markets has already rebounded in recent months.

For now, sovereign yields look set to rise but at a moderate pace, with central banks tentatively trying to exit ultra-loose monetary policies. Credit should remain supported, as the hunt for yield continues. Liquidity remains key, which is why we prefer a barbell strategy in fixed income, with increased cash allocation on the one hand and higher yielding assets, such as emerging-market debt, on the other.

From a longer-term perspective, the fact that central bankers themselves seem puzzled by the low-volatility world they helped originate is hardly reassuring. To be sure, investor demand for income-generating assets should mitigate higher volatility. Moreover, low volatility is not a good timing indicator. It can either lead you to be too early in trading contrarian – or too late, with more severe implications on portfolio risk. Still, it is worth keeping in mind that neither central banks nor other policy makers can eradicate risk forever.

Volatility remains low in U.S. equity markets ...

Volatility remains low in U.S. equity markets

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 02/2017

... but has already rebounded in U.S. Treasuries

Volatility has already rebounded in U.S. Treasuries

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 02/2017

In Europe, equity-market volatility remains low

In Europe, equity-market volatility remains low

Sources: FactSet Research Systems Inc., Deutsche Asset Management Investment GmbH; as of 02/2017

Allocation

Getting slightly more cautious

We are scaling back equity exposure slightly and favor carry assets within fixed income.

The year has started well, limiting overall total-return expectations going forward. Given stretched valuations, a temporary correction looks likely. Within a slightly reduced equity exposure, we favor Europe and emerging markets.

In fixed income, we believe a short-duration stance may be a prudent approach to take. We remain underweight in sovereigns, but slightly less so, as we expect rates to rise only at a gradual pace. Fixed-income credit should remain supported, but the spread environment needs to be monitored closely in the light of central-bank communication.

In this environment, a barbell strategy, consisting of liquid cash-enhanced segments and higher-yielding assets (notably emerging-market debt) may be worth considering. Within commodities, we are positive on cyclical sectors and see gold as a valuable diversifier from a multi-asset perspective.

The chart shows how we would currently design a balanced, euro-denominated portfolio for a European investor taking global exposure. This allocation may not be suitable for all investors. Alternatives are not suitable for all clients. Source: Multi Asset Group, Deutsche Asset Management Investment GmbH; as of 3/29/17

We are scaling back equity exposure slightly and favor carry assets within fixed income.

Multi Asset Indicators

As good as it gets?

Currently, indicators paint a positive picture. Uncertainties remain, however.

The current financial-market environment is mostly friendly as reflected by our multi-asset indicators. Particularly positive signals are coming from the macroeconomic side. Supported by strong fundamentals, the macro indicator has been rising steadily since the fall of 2016. Its high values continue to show a solid macroeconomic base. The euphoria seen after the U.S. elections has recently faded slightly as doubts have risen as to the timely implementation of President Donald Trump’s policies. This is also reflected in the development of the risk indicator, which recently dipped following a continuous uptrend. However, it remains at a high level. A look at the surprise indicator shows that the recently published data in Europe have surprised slightly on the negative side when compared with analyst consensus. The data in the United States and Asia, on the other hand, have continued to surprise positively. Overall, the three indicators paint a positive picture, despite some weakness in the risk and surprise indicators.

Macro indicator

Consumer confidence, trade figures, unemployment numbers: The macro indicator condenses a wide range of economic data.

Macro indicator

Source: Deutsche Asset Management Investment GmbH; as of 3/24/17

Risk indicator

Our risk indicator reflects investors’ current level of risk tolerance in the financial markets.

Risk indicator

Source: Deutsche Asset Management Investment GmbH; as of 3/24/17

Surprise indicator

The surprise indicator tracks economic data relative to consensus expectations.

Surprise indicator

Source: Deutsche Asset Management Investment GmbH; as of 3/24/17

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