The ‘unnatural calm’ currently at play in markets despite huge political uncertainty is making BlackRock’s blockbuster Global Allocation fund team nervous, Russ Koesterich has said.
In a recent blog post, Koesterich, who co-runs the $18.4 billion BGF Global Allocation fund alongside Dan Chamby, David Clayton, and Kent Hogshire, said at this stage of the bull market, investors are contending with more than a few enigmas.
‘Do valuations even matter? Will interest rates ever rise? And how do you explain the divergence between US political dysfunction and the unnatural calm in financial markets?
‘That last one has become particularly troubling. Most volatility measures are near all-time lows while Washington appears in complete disarray.’
Koesterich said the economic policy uncertainty in the US since May has risen with policy uncertainty significantly above where it was pre-Donald Trump election.
‘Yet the VIX Index, a common measure of equity market volatility, is at half of its November peak (see the chart below) and bond market volatility is about a third lower. As surreal as this seems, it is not inconsistent with history.
‘In the past, policy uncertainty has been more likely to coincide with a significant spike in volatility when monetary and financial conditions were tightening.’
However, Koesterich said today we have an opposite set of conditions, as uncertainty continues and the Fed continuously rises rates.
‘Broader financial conditions are easier than they were at the beginning of the year: high yield spreads are tighter, the US dollar is down and the stock market is having a stellar year.
‘As a result, composite indicators of financial stress, such as the Bank of America Merrill Lynch Global Financial Stress Indicator, suggest less stress than in January.’
One thing that could change this state of affairs, Koesterich said, is the relationship between policy and the impact on the wider economy.
'Policy uncertainty could morph into systematic stress, for example, the failure to raise the debt ceiling later this year,' he said.
'A more likely catalyst would simply involve tighter financial conditions, potentially a result of the simultaneous withdrawal of monetary accommodation by the Fed and the European Central Bank.
'But as long as money remains relatively cheap and plentiful, investors are likely to stay unperturbed by political paralysis and dysfunction. When that starts to change, political uncertainty may suddenly morph back from farce into tragedy.'
Over the three years to the end of July 2017, the BGF Global Allocation fund returned 9.01% in US dollar terms. This compares with a 17.52% rise by its Citywire-assigned benchmark, the LCI S&P500/MLUSTr5+/FTSEWxUS/CitiN-US (36:24:24:16), over the same time period.