By Hiten Savani
The past five years have seen market behaviour dominated by elevated levels of macro and policy uncertainty. This has affected the structure of markets with a limited set of factors explaining a large portion of price returns and high correlations between and within asset classes. More recently there have been several indications that a shift in focus from macro to micro fundamentals has begun.
Looking ahead we believe this trend will continue as policy and macro uncertainty gradually decline and the average level of idiosyncratic risk continues to rise. This presents a clear opportunity for fundamentally focused investors who should be well placed to benefit from this transition.
The way in which risk assets have traded in the past five years has been materially changed by the impact of the credit and sovereign debt crises. These shocks have been systemic and characterised by uncertainty related to the effectiveness of subsequent policy initiatives. Markets have been driven in large part by macro factors for which risk is notoriously difficult to price.
The degree of political uncertainty and other opaque exogenous factors have dramatically impacted market returns, average correlation between and within asset classes, the level of market fragility and the extent to which valuations reflect micro fundamentals.
In such a risk on-risk off environment it is important to look at several measures of market structure and risk, especially when volatility measures seem to indicate things are better than they are.
Despite a series of policy initiatives, economic recovery has been sluggish. With fiscal and monetary policy space now very limited, the consensus view is that growth will continue to be anaemic with interest rates remaining low for an extended period. Market participants have had several quarters to improve their understanding of the major macro risks. Clarity related to the eurozone, US fiscal cliff and other systemic issues is likely to improve further. Already, there has been a fall in the spread of economic forecasts since 2010 and political uncertainty appears to have peaked.
The beginnings of a gradual shift in focus away from macro and policy is reflected in a decline in correlations, market fragility and an increase in average idiosyncratic risk, a trend we believe will persist and which presents an opportunity for fundamental investors.
While broader risk on-risk off behaviour is unlikely to disappear altogether, we believe managers who remain wedded to a fundamentally driven investment thesis reflected in high active money, limit turnover and who strive to diversify portfolios in order to control absolute volatility have a better chance of success in the medium term.
Hiten Savani is investment director at Fidelity Worldwide Investment
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