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Q: Should I be worried about the recent weakness in major equity markets?
A: The heightened volatility in equity markets over the past few months seems to exaggerate the risks that are currently facing Western economies. There is always a temptation to believe markets are telling us something; implying that weakness is warning us of greater economic risks than currently perceived. We do not believe this to be the case. In fact, there are technical reasons why markets might be more bumpy.
Since the financial crisis, regulatory authorities have restricted the amounts of capital that investment banks can commit to holding proprietary positions in equities. In our view, this has removed one of the shock absorbers that, in some circumstances, used to dampen volatility. In effect, a change in sentiment or simply an increase in uncertainty will tend to lead to more volatility if, in markets where there is some modest selling pressure, most investors simply decide just to sit on their hands. The result has been declines in some equity markets that seem to significantly overstate the underlying economic risks.
That is not to say that we are totally sanguine about the outlook for financial markets, particularly equities. We believe that many investors have not yet adjusted downwards their expectations for equity market returns in line with likely lower trend growth rates in most economies. Equally, we remain concerned that, partly as a result of previous and continuing quantitative easing, government bond yields are appreciably too low and provide insufficient protection against inflation risks. It is also the case that investors and economists have still to come to terms with monetary tightening.
Against this backdrop, holding equities, whose performance is more aligned to a period of lower economic growth and which allow for the risk that higher inflation is tolerated by policymakers, remains a sensible strategy.
The article is for information purposes only and should not be interpreted as investment advice.