Investors shouldn’t get carried away with the positive performance of markets in the opening weeks of 2019, according to Nomura Asset Management’s Dickie Hodges, who says that “where you have complacency, it gives life to volatility”.
Hodges, who manages the $347.9m Nomura Global Dynamic Bond fund, said last year reminded people that volatility is part and parcel of markets, following its absence in 2017.
The market was jolted back to life by several different factors in 2018. The growing US-China trade dispute continued to cast a shadow as president Donald Trump toughened his stance. The fall-out also started to impact other countries as the established norms of international trade came under pressure.
Meanwhile, the Federal Reserve’s interest rate policy also came under scrutiny as some analysts began to worry that the central bank could raise rates too quickly and slow US growth.
“We were always aware that they would increase rates but what we weren’t aware of was where they would go to,” said Hodges.
Additionally, the end of the quantitative easing models employed since the global financial crisis, responsible for much of the surge in asset prices over the past 10 years, also threatened to remove liquidity from the market.
“It really is the withdrawal of liquidity that freezes markets and it’s reflected in the pricing of assets,” said the Nomura manager.
“We saw oil fall considerably in the last couple of months of 2018. We saw considerable amounts of equity volatility in comparison to what we saw in the whole of 2017 and that caused a massive price depreciation which I wouldn’t necessarily say was a true reflection of sentiment of the considerable concerns of investors. It was, in my opinion, an aberration.”
Performance of fund vs sector in 2018
Source: FE Analytics
As such it proved a difficult year to generate positive returns. Hodges’ fund was down by 1.37 per cent in 2018, but the average IA Sterling Strategic Bond peer fared even worse, losing 2.49 per cent.
While last year proved challenging for fund managers, however, it ended with a great opportunity.
“In the final months of December, suddenly everyone took the view that the US was rapidly moving into the probability of recession and risk assets started pricing in that probability,” said Hodges.
“We saw this in equity market valuations falling, in government bond yields rallying quite considerably as liquidity drove markets to extreme.
“I think they were too early in assuming that the US and therefore the global economies were moving into a recession.”
The manager added: “That actually threw up a lot of opportunities in December and clearly what we’ve seen in the first month of this year is that markets are just returning back to the level they were at the beginning of December 2018.
“I think this has been a liquidity-driven event that has pushed risk assets lower and pushed volatility higher.”
One of the ways in which Hodges was able to take advantage of December’s sell-off was in making use of options in the Nomura Global Dynamic Bond fund – with put options on equity markets in Europe, Japan and the US and in call options on US government bonds.
“I know this is a fixed income fund but you’ve got to be able to have the ability and flexibility to use tools to mitigate risks and look to protect on the downside,” he said. “The fund was positioned correctly for the sell-off that we saw in risk assets and lower bond yields we saw globally in December.
“But then the whole of the positioning accelerated far too quickly so in the end of the week prior to Christmas we monetised all the options strategies that we had put in place: all the equity puts we sold and locked in place all the call option strategies on government bond yields.”
Performance of MSCI World in December 2018
Source: FE Analytics
Yet, while markets seem to have recovered much of December’s losses during the first few weeks of January, Hodges said it would be dangerous for investors to extrapolate such performance for the remainder of 2019, particularly given the known challenges later this year.
He explained: “We did know from the middle of December that the increase in tariffs that Trump had proposed at the beginning of 2019 were pushed forward 90 days to the end of March.
“I think this is fairly significant in as much as that’s when we start having a lot of events coming through: it coincides with Brexit, it coincides shortly afterwards with European elections and also a number of global elections principally in places like India and the emerging markets.”
The Nomura manager added: “There is enough volatility and uncertainty ahead of us certainly within the first six months of 2019. You’ve got to be very careful about drawing any conclusions on the first 14 days.”
One of the biggest challenges facing UK investors in particular this year is Brexit, but Hodges believes that a ‘hard Brexit’ is now much more unlikely as Theresa May continues to negotiate the UK’s exit from the EU.
Few MPs have signalled their support for a hard Brexit and with the prime minister now seeking out the opinions of all political parties and factions following the defeat of her deal, such a scenario seems increasingly remote.
“I actually think the probability has shifted to a ‘soft Brexit’ or no Brexit at all,” he said. “Contrary to what other people think, the probability is much lower of a hard Brexit regardless of headlines in the national press and on the news.”
While Hodges said he does not believe that the UK will leave without a deal on 29 March, he has taken some precautions.
“I’m covered on both sides which is how I like to be at the moment, but I know what the cost or drawdown to the strategy in either position is,” said the manager. “These strategies don’t expire until very late 2019, I’ve covered that uncertainty that we will see at the end of March.”
He said: “I’ve got a simple option strategy that will generate positive returns and will benefit from the British pound versus the US dollar increasing in value, the pound rallying [in the event of a soft Brexit].
Performance of sterling vs US dollar since EU referendum
Source: FE Analytics
“Elsewhere, I’ve got interest rate strategies that would also benefit. I’ve got put option strategies on UK interest rates.
“If the pound falls and the Bank of England and [governor] Mark Carney decided to step in and contain the fall in the pound – because a considerably lower pound would increase the probability of inflation quite measurably – I’ve got an options strategy if the Bank of England decides to raise interest rates.”
The Nomura Global Dynamic Bond fund has an ongoing charges figure (OCF) of 0.76 per cent.