Market jitters: a comment

What should we make of current market developments? The headlines in the UK focus on Brexit and the impact that this is currently having on markets. While there is little doubt that the impending Referendum is unsettling financial markets, to focus on this alone would not give the full picture. To understand fully one should step back and take a global perspective.

Since last August, financial markets have been subject to bouts of considerable volatility and vulnerability. Then it was the unexpected Chinese devaluation. Since then markets have, at various times, been worried about the current state of the Chinese and US economies and about both the direction of US interest rates and its wider implications. 

So even though the trigger for current stock market wobbles is Brexit, the underlying issue for some months has been concern about the world economy - and whether as a result markets were overpriced? The poor recent jobs data in the US caught many unawares and flew in the face of other recent US indicators. But it did make many sit up and ask, where is the US in the economic cycle? Is the recovery about to run out of steam? Of course there was an additional worry. The Fed hiked in December and the economy did not react well. Could the same happen again? The Fed has tried to reassure with its recent statements, stressing it will assess all the data.

While the Fed has until recently been talking of higher rates, at the recent G7 meeting in Japan it was made abundantly clear that fiscal and supply side policies need to be used more across many economies, not just monetary policy. So markets too are acutely aware of the limits of current policies, whatever the immediate economic need.

All of this has led investors to be wary and global markets to be vulnerable, hence the general reaction to the latest series of opinion polls here in the UK showing the Leave side ahead. Brexit is the trigger for the latest sell off in equities and a flight to quality in bonds, but markets could easily have been volatile anyway.

Although the idea of negative long-term bond yields may fill many private investors with shock, from an institutional perspective there may be a different perspective. There is a need to invest and safe assets, despite low or even negative rates, offer security -- a few years ago it was referred to as a return of one's money not a return on it. Also, as Japan has demonstrated for some years now, it is not just the level it is the expected direction of rates and yields that is key. Even if yields are low or negative, if they are expected to fall further then this provides a healthy capital gain.

Switzerland has been the safe haven in recent years in the face of problems in the euro zone, and the strength of the Swiss franc has reinforced that. This has been compounded by the latest uncertainty, but in addition, within the Eurozone itself, Brexit would expose differences between the core and the periphery of the euro system. Hence Bund yields are now, too, in negative territory. Judging from what has happened to Swiss bonds yields, they could even head sharply lower. Prices of periphery bonds in the Eurozone would be more exposed to volatility were Brexit to occur.

The issue to finish with is whether markets are pricing properly for risk? The idea of yields being this low would make many say no. Even in Germany, there are longer term concerns. It was only in 2014 that the Bundesbank highlighted that 32 of Germany's 85 life insurers had problems with yields at 1.5%, we can only assume that number is higher as yields head lower. It is another sign of the challenges posed by low yields. But for now, markets and investors are focusing on safety.

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