Giles Hargreave: get ready for volatility

“Despite the heightened political drama, Brexit negotiations and (modest) increase in the Bank of England base rate, UK equities finished 2017 in firmly positive territory,” says Giles Hargreave of the Marlborough Special Situations Fund. And it wasn’t just the UK that did well – far from it. Global shares “were unusually consistent in 2017: equity volatility touched record lows and the MSCI World index posted gains each month for the first time ever”. The main factors driving these gains were “unexpectedly strong and synchronised global economic growth, good earnings growth, low reported inflation and extremely easy monetary policy”. Can it continue?

Hargreave notes that “a recession currently appears unlikely”. And so it is possible that share prices could continue to rise. However, “it is highly probable that volatility will increase”. That’s partly down to the fact that stockmarket valuations “are above their historical averages (particularly so in the US)”. But the bigger factor will be monetary policy. Central banks have added roughly $15trn to their balance sheets since 2008. Yet by the end of this year the main central banks – the Federal Reserve, the European Central Bank and the Bank of Japan – “should, in aggregate, be contracting their balance sheets”.

Of course, as Hargreave admits, it’s impossible to forecast future bond yields precisely. However, the question now is not whether the Fed will continuing raising rates, but how quickly it will do so. And this, in turn, is already having an effect on long-term government bond yields, with ten-year interest rates in the US already rising close to 3%. As for the UK, the Bank of England will be forced to follow suit, says Hargreave. “Given the historical correlation” between rates in the US and UK, as well as above-target UK inflation, “a UK base rate of 0.5% appears unsustainable”.