Past performance is not a guide to future performance and may not be repeated.

In the fixed income world, the best performance within government bond markets came from UK gilts as a slowing economy and Brexit uncertainty made the safe haven asset more attractive. US Treasuries also performed well, although most of this was as a result of the unwinding of the “Trump trade”. As for credit markets, US markets outperformed their European peers comfortably, against a backdrop of falling bond yields but rising equity markets.

Amongst currencies, the euro and yen have both performed well on a trade-weighted basis, while the US dollar has depreciated. Most other currencies have remained stable.

Are current trends sustainable?

The fall in government bond yields alongside the ongoing rally in equities suggests investors are split on the current outlook. Volatility remains very low despite the Federal Reserve’s (Fed) tightening policy. While liquidity is ample and has in the past been a major factor in causing these markets to move in the same direction and suppressing volatility, history suggests that this trend is unsustainable.

The fall in oil prices is a possible factor for the current state of markets. Although lower oil prices will hit the energy sector, with lower inflation ahead, some central banks like the Fed and Bank of England may become less ambitious in tightening monetary policy, while some, such as the European Central Bank (ECB), may be forced to step up stimulus again. This suggests risk assets¹ could continue to do well, especially as growth continues unabated, while inflation remains low.

Are investors complacent?

The strength of equities against a backdrop of falling bond yields and elevated political uncertainty has raised the question as to whether investors are becoming complacent. Their complacency is evidenced by the new lows seen in the Chicago Board Options Exchange (CBOE) Volatility Index, often referred to as the "fear gauge".

It could be argued that volatility is low because investors are now comfortable with the three primary factors that have driven volatility in recent years. Specifically, concerns about the Fed tightening monetary policy, China’s currency policy and the oil price have all eased. We would add that the current low level of volatility today also owes something to favourable political outcomes in Europe where there has been no swing toward populism.

Threats to low volatility

That said, the next shock to markets may not be driven by the Fed, oil or China. It could be geopolitical in origin, for while political risks may have eased in Europe, they are building in Asia. Notwithstanding such an outcome, of the three main drivers discussed, Chinese currency policy seems to be less of a concern although the oil price risks falling further.

The greatest worry is on US interest rates where the market appears to be underestimating the potential for higher rates. The desire to normalise remains high and rates are still well below where most models would have them given where the US is in its economic cycle. At present the market is only discounting one, or possibly two, more rate hikes to the end of 2018. Meanwhile, the Federal Open Market Committee (FOMC) members put rates at just over 2% at the end of 2018.

Complacency may be hard to resist

However, such pressures will not become apparent until further out. Low inflation will keep the Fed cautious and the start of balance sheet reduction will probably see the Fed pause rate rises for six months to monitor any more general tightening of financial conditions.

Unless the Fed signals otherwise, the difference of opinion between the market and the FOMC may not be resolved until spring next year. Meanwhile, central bank asset purchases are likely to continue to expand.

In this environment investors may find it hard to resist being "complacent" as liquidity will continue to drive markets with the risk that they move into bubble territory.

^{1. Risk assets are those that have a significant degree of price volatility, such as equities, commodities, and high yield bonds.↩}

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