Asset prices have generally been rising globally since 2003. The period has been remarkable for global markets, not just because of the gains made, but because they have been achieved with relatively low volatility.

Opinions are mixed about why volatility has been lower than historic norms. It does, however, imply that investors see less ‘risk’ in most asset classes. This apparent complacency has seemed odd given geopolitical tensions, high energy prices and the build up of global imbalances in trade and capital flows, especially in the United States, which continue to worry observers and policy makers.

That returns have been highly correlated in recent years in normally disparate asset classes such as government bonds and gold bullion, for example, suggests to us that plentiful liquidity due to low interest rates has been more influential in driving markets than fundamentals.

Some see the reduced volatility in financial markets as a direct, and rational, response to a more stable economic environment. The global economy has seen the more extreme growth cycles of the post war decades give way to our current experience of mini-cycles, with relatively low and stable inflation. Stability is ‘in’; central banks are targeting it, politicians are taking credit for it and, as is usual with benign trends, many observers are projecting it indefinitely into the future. The key tenet for such a view is the not unreasonable belief that globalisation, along with technological change, has fundamentally changed the trade-off between growth and inflation. While we agree that this has been, and may remain the case, it is dangerous to simply extrapolate trends. We should not expect that the potential for disinflation emanating from the developed world (and particularly China) is either consistent or inexhaustible.

We have been concerned for some time that, although the exterior may look calm, tensions have been building beneath the surface tensions. These tensions include high asset and commodity prices, unprecedented levels of US consumer debt, rising trade imbalances, a global economy where growth has accelerated and broadened out, and, perhaps not surprisingly, emerging concerns about inflation. The combination of the above has led central banks globally to increase interest rates. Additionally, the Bank of Japan has clearly signalled that the era of ‘free money’ is coming to an end by aggressively withdrawing excess deposits (¥30 trillion in total) from the banking system as can be seen in the following chart:

We have expected for some time that some or all of these factors could trigger a re-assessment of risk in financial markets, that volatility would pick up and that a cautious approach was warranted.

As the chart below shows, after declining for the last three years, the volatility index of the US market is rising.

This appears to be what we are currently experiencing in financial markets: although underlying economic fundamentals have not radically changed, the risk environment has. How the stresses and strains resolve themselves is crucial to the outlook for financial markets.

One thing is however becoming clear; investors are increasingly sceptical about whether robust growth can continue to cohabit with low inflation. In our opinion, this is a justified concern. The current low inflation readings in the developed world represent a balance between globally traded/manufactured goods, which are broadly deflating, and the domestic service sector and administered prices, which are not.

In the US, the authorities have neatly constructed inflation indices which include globally traded consumer goods, such as textiles sourced in Asia but exclude so-called volatile inputs such as energy and food costs, which are likely to be adversely affected by the westernisation of the developing world. In addition, US inflation also excludes the direct impact of house price inflation, and consumers could be forgiven for not feeling that the inflation indices match their real-life experience.

Heightened concerns about inflation and interest rates are likely to mean that financial markets become much like the US Federal Reserve, data dependent and, therefore, increasingly short-term in their view. Evidence of stronger growth is likely to be bad news, as it could lead to too many interest rate increases. In this scenario, already overly indebted consumers – particularly US consumers who still represents 20% of global growth – may be forced to retrench, with significant negative and unpredictable consequences for the global economy.

A more likely scenario is that a slowdown in global economic activity is already happening and that interest rates are likely to peak earlier and that inflation concerns subside fairly rapidly. A severe deceleration of growth could cause market sentiment to swing back to concerns about deflation – now a distant memory.

What we are suggesting is that sentiment about growth, inflation and interest rates has the capacity to swing widely in the coming months. Financial markets are likely to reflect that volatility. Although this makes portfolio policy difficult, in most scenarios risk aversion will continue to rise. Economically sensitive parts of the equity market should lose their lustre and, in time, government bonds should gain support. Although in the long term, we favour developing world equities, there is little doubt that the near term could be difficult. Stable companies with predictable cash flows should fare best when the dust settles. Indeed, some of these in sectors such as healthcare, pharmaceuticals and telecommunications have been deeply out of favour in the recent past.

In the longer run, our themes will continue to drive stock selection with the low return world, and its characteristics of pricing power, supply constraint and yield becoming increasingly important criteria in our stock selection process.