A crack in the global growth story that has brought markets to all-time peaks could lead to an increase in volatility, according to Natixis Investment Managers’ chief market strategist David Lafferty.
Volatility has been at record lows this year, but investors polled by Natixis for its Institutional Investor Outlook for 2018, a survey released this week, said that's bound to change.
A full 78% of the 500 institutional investors surveyed said they expected higher volatility in the stock market in 2018, and 70% made the same prediction for the bond market.
Speaking at a press lunch Tuesday, Lafferty and David Rolley, co-head of global fixed income at Natixis affiliate Loomis, Sayles & Company, outlined the factors that could trigger the spike.
‘For bonds it’s easy: an inflation surprise in the United States on the upside. Inflation is bond poison. The consensus expectation is an average inflation rate of 1.9% for the next 10 years and that’s what’s baked into prices. We surprise on the upside, bonds are going to do bad,’ Citywire + rated Rolley said.
‘I think stocks tolerate that well because they have embedded inflation protection. Their surprise would be a serious loss in earnings momentum - an earnings disappointment. At these [high] valuations, you have to keep earnings going.’
Digging deeper, Lafferty said investors were currently making a bet on the status quo of a global synchronized growth environment that has driven earnings growth.
‘If you put that aside, you’re looking and find that the central banks are pulling back, inflation surprises are out there, geopolitical risk growing, and valuations are fairly high,’ Lafferty said.
‘If there is a crack in the global growth story that to me is the dominant potential risk that’s out there.’
Living in a bubble
Investors have made riskier bets as they look for higher yields, so some assets classes have become crowded and might be headed for a bubble, according to the Natixis survey.
Despite the potential bubbles and volatility spikes, 64% of investors said they think they could achieve their return expectations of 7.2%.
However, Rolley said that expectation is ‘not realistic at all.’
‘If all the good news is already in here and investors have all responded on the poll that they think the asset markets are expensive, then extrapolating a [7.2%] return doesn’t make any sense to me,’ he said.
‘I think that there will be ways to get to acceptable returns, but it will involve a lot of non-traditional methods and that would mean being a lender to smaller companies, being a lender to emerging borrowers, looking at equities in other countries, looking at currencies.’