Harmony – with off notes

Multi Asset

In the third quarter, a familiar trio, good economic data, political disappointment and patient investors, combined to produce a remarkably happy melody in the markets. We think they will also provide the music for the final quarter of the year. Although some emerging markets started to go badly out of tune in the summer, the global economy as a whole remained harmonious. And even though by June 2019 the United States could set the record for the longest economic upswing in post-WWII history, we are having a hard time finding reliable indicators that suggest the cycle will end soon – at least when we look at traditional models.

And yet we see the potential for threats disturbing the market's harmony as politics throws out more and more wrong notes and central banks start to sing from a completely different hymn sheet. In Europe, Brexit and anti-globalization populism are entrenched as long-term sources of discord. The latest signals from Rome to Brussels could also prove an enduring headache. Meanwhile, some emerging markets are coming up with sour notes that are reminiscent of times past. And the new, unorthodox foreign and trade policies of the U.S. are highly unpredictable and have the potential to create discord. The central banks are doing all they can, but they have a new priority: the serious business of shortening their balance sheets.

Politics and the changing tune of the central banks could test the nerves of the third element of the trio: investors. They have been kept happy in part by large doses of a calming drug called monetary expansion. What has also reassured them is that so far none of the political hotspots has succeeded in throwing global GDP growth off course. Therefore, every market setback has been seen – for good reason – as a buying opportunity. And, indeed, those who avoided the riskier, higher-yielding asset classes because of the imponderables alluded to above are now feeling left out and are thinking twice about playing it safe. An environment of this kind fosters complacency and a more relaxed attitude towards risk. That is evident now in historically high valuations and volatility which, while not at the record lows of last year, has escaped the turbulence at the beginning of the year. It is indeed in very quiet waters again – though this is only true for the most popular volatility indicator, the volatility implied in futures contracts.

Alternative indicators paint a very different picture. Take, for example, the CBOE VVIX Index (VVIX), which measures the implied volatility of VIX options on the S&P 500. So far this year, the average VVIX reading has been above all annual averages calculated since the index was created in 2007. A second source shows underlying strain: kurtosis , which describes the shape of a probability distribution. Applied to capital markets, this measure shows the extent to which price fluctuations are normally distributed or characterized by extreme fluctuations. In a normal distribution, the kurtosis reading is 3. As the chart shows, the S&P 500 occasionally rises above 3, but it has never been as high as this year.

Exactly why market reactions are currently more often outside the "normal" bandwidth of expectations is a topic for another time. It may be the current cluster of political events with highly uncertain outcomes and a potentially major impact on capital markets. At any rate, we think the market fluctuations will tend to increase rather than diminish in intensity. That may sound bad since investors are afraid of uncertainty, but we also see a silver lining. Namely, that thorough analysis is needed and may be rewarded. Investors must conduct a careful analysis and gauge how much faith they put in different outcomes. They must then deduce the level of risk that is acceptable to them and take appropriate positions. Risk management of this kind is ultimately one of the core missions of Multi-Asset Management – and a potential source of added value.

The volatility of the S&P 500 may be at an all-time low, but there is more anxiety in the index than assumed, as evidenced by the VVIX.

Source: Thomson Reuters Datastream as of 10/5/18

Kurtosis reveals what the price chart of the S&P 500 does not: unusual times.

Source: Bloomberg Finance L.P., DWS Investment GmbH as of 09/2018

* Kurtosis describes the shape of a probability distribution curve. The higher the number, the more outcomes occur at the tails of the curve.

Allocation

Little has changed over the past quarter. The economy is at an advanced stage of the cycle, which in our view continues to favor higher yielding asset classes, even if volatility might increase. Therefore, we continue to favor equities over corporate bonds. In particular, European and Japanese equities should have catch-up potential due to seasonal factors, while emerging markets may remain vulnerable. For fixed income, however, selected emerging markets with solid fundamentals remain the preferred choice due to their generally higher yield levels. Commodities are more likely to show signs of consolidation following energy-price increases. For the time being, we have no particular preference for any major currency pair.

Source: Multi Asset Group, DWS Investment GmbH as of 9/25/18

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 and can be changed at any time without notice. Alternative investments involve various risks and are not necessarily suitable for all clients or for every portfolio.

Indicators

In the third quarter, indicators again mirrored the ups and downs of the markets and the mood swings of investors. As in the first half of the year, the risk indicator was very volatile. Following a recovery in July, global uncertainties led to increased risk aversion, particularly in early August and again in early September. The risk indicator has been signaling a friendly environment again since mid-September, in particular as a result of the stabilization in emerging markets.

On the fundamental side, the signals and changes were less strong. The macro indicator steadily deteriorated from a very high level in the first half of the year but has now stabilized and is neutral. Currently, neither a growth spurt nor an impending recession is indicated. The surprises were also less strong. From mid-August to mid-September, data releases were rather disappointing globally. Apart from that, however, data largely met analysts' expectations and often even surprised positively, especially in September in the United States and recently also in Europe.

All in all, our three indicators paint an optimistic late summer - but they are likely to turn down if autumn storms approach.

Condenses a wide range of economic data

Source: DWS Investment GmbH as of 10/4/18

Reflects investors’ current level of risk tolerance in the financial markets

Source: DWS Investment GmbH as of 10/4/18

Tracks economic data relative to consensus expectations

Source: DWS Investment GmbH as of 10/4/18