Always expect the unexpected

Just when it felt like markets were settling down a bit after another volatile summer, things changed again early last week, says Valentijn van Nieuwenhuijzen (pictured), Head of Multi-Asset at NN Investment Partners…

After the Bund market shock in April-May, the latest Greek tragedy in June and early July and the commodity shake-out that started in late July, it seemed that some calmness had come back to investor behaviour in early August. But just when some sideways patterns in bond and equity indices were starting to emerge and (implied) volatility measures had fallen back again, the wires flashed some unexpected policy news. The surprise factor was not the widely anticipated shift in US monetary policy or new QE action in either the Eurozone or Japan, but the first devaluation of the Chinese renminbi in more than two decades.

It did not take long before markets again started reflecting more risk-averse investor behaviour. The change in the currency regime of Chinese policymakers fuelled fears of escalating "currency wars", erosion of Chinese policy makers' credibility and rising market fragility through contagion into commodity markets, or sectors, or regions sensitive to commodity dynamics. Moreover, the unexpected nature of the move introduced substantial uncertainty into the market outlook, as the probability of further renminbi devaluation has increased substantially despite effort from policy makers to suggest this was a "one-off" adjustment.

These developments illustrate once again how the market ecology evolves. Financial markets are a huge, complex adaptive system rather than a self-stabilizing system that oscillates around a fundamental anchor. There are large path-dependencies in the future states of markets. All players in the market and the underlying fundamentals are mutually dependent. In other words, the state of the overall system influences behaviour of underlying components, which themselves influence the state of the system. The degree of this influence varies over time; the causality of feedback loops between markets, investors and the underlying economy can shift as well.

The uncertain dynamics this creates in our global financial system make markets more risky than finance theory suggests, as extreme price moves are much more regular than they "should" be. Also, it causes market volatility to run in streaks as the clustering of turbulence as seen in recent months happens regularly – it happened in the autumn of last year and in the summers of each of the previous four years. The intermediate periods, meanwhile, can be remarkably calm and steady.

All this gives Mr. Market his own personality, a character that emerges from, but is greater than, the sum of the parts. Mr. Market’s mood swings are determined just as often by the inner workings of markets themselves as they are by outside events like unexpected policy maker moves. Both probably play a role most of the time.

All this does not tell us what to do with the latest policy surprise from China. It does remind us to always expect the unexpected and it explains why a relatively small "outside" event – in this case, a 3% fall in the renminbi -- can create much larger ripple effects in global markets. If such a negative surprise comes when Mr. Market’s inner working is in a fragile state, it might depress his mood much more than the "fundamentals" seem to justify. As is the case with our own behaviour in real life, it is amazingly difficult to know in advance how Mr. Market will respond to unexpected events, how long he will stay emotionally impacted by them and how his resulting behaviour influences his environment.

The only certainty right now, therefore, is an increase in uncertainty on the back of renminbi devaluation. This keeps us on guard to further adapt our asset allocation stance if the risks start to increase that Mr. Market will not shake it off and that negative market sentiment starts building on itself. For now, a balanced overall stance with a preference for real estate and equities over fixed income spreads and commodities is maintained

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