Volatility, opportunity, and investment strategies in the second half

Today we have a guest post by Dr. Sudhir Krishnamurthi, Kenneth LaPlace, and Ronald van der Wouden from The Rock Creek Group, LP. They are the portfolio managers of the Wells Fargo Advantage Alternative Strategies Fund.

Dr. Sudhir Krishnamurthi

Dr. Sudhir Krishnamurthi

2014 continues to be a busy year, but it would be hard to tell by looking at volatility in asset prices. Equity volatility, particularly in the U.S., has reached its lowest level since the financial crisis in 2008. Even the brief spikes are smaller and shorter. However, we continue to believe that this environment will change.

We believe the main reason for the depressed volatility has been the unforeseen amount of liquidity that central banks have pumped into the economy. Although the European Central Bank (ECB) recently announced a new quantitative easing program, the Bank of England and the U.S. Federal Reserve (Fed) are getting much closer to reversing this trend. Given that we are six years into the economic recovery, it is normal to expect the pendulum of monetary policy tostart swinging in the other direction. This, combined with the fact that banks are much more limited in their ability to serve as liquidity providers due to changes in the regulatory framework, makes us cautious at this juncture.

As is the case in situations in which asset-price volatility steadily declines, asset prices have been moving higher. Equity risk premiums, which reached all-time highs in 2013, have come down significantly. Although valuations are not in bubble territory by historical measures, the upside/downside from here on out is much more balanced than it was over the past year. Most equity-market bulls currently respond to questions about why they believe markets will move higher by saying that these markets are still the more attractive asset class on a relative basis. However, as we head into a period where central banks will need to tighten liquidity due to lower unemployment rates and increasing inflation, this thesis will become harder to support.

Look to inflation, data as indicators of market performance

Kenneth LaPlace

Kenneth LaPlace

Moving into the second half of 2014, we believe that economic data in the U.S., particularly on the inflation front, will be a key driver of market performance. Several Federal Reserve Bank presidents have already shared their view that progress on the employment front has been better than their forecasts. Unless there is a reversal in the trend of decreasing unemployment, a potential pickup in inflation would likely intensify discussion on the timing and the amount of Fed rate hikes.

Across the pond, European assets are likely to react to global sentiment and geopolitical events more than they will to economic data in the near term. Although inflation and credit to the private sector are two key indicators to watch, in the near term, we do not expect markets to have strong reactions to changes in these indicators given the ECB’s recent stimulus measures. Any further declines in inflation and private-sector credit should be balanced with the view that the ECB’s new stimulus measures will take some time to kick in.

In Japan, economic data took an expected downturn after a sales-tax hike came into effect on April 1—but both economic activity data and surveys bounced back quickly, and the Japanese equities market has been trending up in recent months. Going forward, we expect Prime Minister Abe’s corporate reform package to create volatility in Japanese markets. Although we think the initial reaction could be muted, over time, we expect to see increased participation in labor markets and corporate taxation changes that willlikely meaningfully affect income, spending, and capital expenditures.

Strategies for an environment of increasing volatility

Ronald van der Wouden

Ronald van der Wouden

The question now is which investment strategies will offer the appropriate risk/reward trade-off in what will likely be an environment of increasing volatility. Despite rising tensions in certain corners, particularly Ukraine, Russia, and the Middle East, we expect the global growth picture to remain intact. However, much remains in the hands of policymakers, which, to us, means investors should be ready to take advantage of idiosyncratic opportunities and tilt toward active management.

With Europe still in a nascent recovery, policymakers are likely to be accommodative for some time. The recovery in Europe is still fragile, which could lead to potential distressed credit opportunities. However, economic sanctions placed on Russia will likely hurt European economies in the short term, and with the dollar currently stronger than the euro, we don’t see European equities as a favorable investment for U.S. investors.

Japanese equities have a better outlook than their European counterparts. Stimulus measures appear to be taking effect, providing a good tailwind. The potential for the Bank of Japan to introduce further quantitative easing measures remains in the cards, especially if exports continue to decline in the face of a stronger yen.

In the U.S., equities have reached rich valuations, with some notable sell-offs in recent weeks. While U.S. equities will likely continue to perform moderately well despite those rich valuations, we prefer activist, long-short, and event-driven strategies. We also seek to take advantage of certain themes, such as bank consolidation and new developments in technology and health care. With the Fed expected to raise interest rates at a deliberate and measured pace, we prefer to overweight floating-rate and securitized assets.

This website is accompanied by current prospectuses for Wells Fargo Advantage Funds®.

 

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