There was no refuge for investors in June--other than in cash–as global stocks sold off, Treasury interest rates rose, credit spreads widened, and commodity prices fell. The turn in markets was fueled by indications from the Federal Reserve that it could begin tapering its accommodative monetary policy as early as September. Emerging country stocks and bonds were particularly hard hit as the broad sell-off in risky assets was exacerbated by reports of slowing growth in these economies, in addition to an apparent liquidity crunch among Chinese banks and political turmoil in Brazil and Turkey. Furthermore, a dramatic rise in interest rates took the shine off certain sectors—for instance, Treasuries and TIPS--that otherwise have done well in a risk averse environment. Collectively, market reaction to the Fed’s plan created a tightening of money and an increase in real rates, causing a re-pricing of risk across markets. Notably, Risk Parity, with risk balanced exposure across many asset classes, performed poorly amid the surprising increase in rates.
While the market reaction to slower growth and a less accommodative Fed has been quick and is likely already incorporated into asset prices, we expect market volatility to remain elevated in the near term, especially as trading activity slows over the summer. Additional negative headlines are possible and so is the potential for ripple effects in areas such as peripheral Europe or other emerging economies. At this time, however, we do not see imminent danger of systemic-level contagion similar to the fall of 2008. That said, we continue to be vigilant as we track market movements.
It is important to reflect that the strong performance across most asset classes leading into this period of volatility provides somewhat of a cushion; for example US equity markets remain up over 13% so far this year. To be sure, the market unrest has also created opportunities. We believe clients can invest in attractively valued risky assets, such as emerging markets, on the back of the sell-offs. The premium for illiquid assets continues to appear attractive for strategies--such as direct lending--that seek to benefit from the withdrawal of banks from making loans to certain market segments. For corporate defined benefit programs, the dramatic backup in interest rates along with gains in equities so far this year, may represent an opportunity to capture funded status improvement by shifting from growth-oriented to liability-hedging assets. That said, we believe any such changes in allocation can be made gradually over the coming months given the currently elevated level of volatility.