Markets prepare for more bond and equity volatility

M&G and Aberdeen are predicting volatility in equity and bond markets will continue in the medium term as traders and institutions move to hedge positions in the face of market moves.

John Hatherly, head of research at M&G Investments, says there have been four double-digit rallies over the course of the current bear market.

The first covered most of the last quarter of 2001, following the September 2001 terrorist attacks in the US. This was followed by markets drifting sideways until a heavy sell off in May in the wake of the Enron and WorldCom accounting scandals. Two more rallies followed, in late July 2002 and early October respectively, prior to the latest this month. 'Most of the activity has been on the trading front and most private investors have stayed out of the market. It is very difficult to call a bottom to this market and I wouldn't rule out markets slipping back further because there are plenty of precedents,' Hatherly says.

'We have seen four rallies within this bear market already. The last three have been as volatile on the upside as on the downside and have been followed by the market trading sideways before succumbing again,' he adds.

Derek Fulton, senior global fixed income fund manager at Aberdeen Asset Managers, expects markets to remain volatile beyond the Iraqi war as investors await any potential further action against so-called 'axis of evil' countries.

He notes more immediate domestic volatility in the bond markets was caused by the Bank of England's Monetary Policy Committee voting eight to one to keep interest rates at current levels. This, coupled with mixed reports about the progress of the war, has pushed the yield on 10 year gilts up 50 basis points over the last three weeks.

'It was expected UK rates could be as low as 3.2% by the end of the year, but now it looks unlikely there will be any rate cut. It was a very pronounced change of expectation and when you have institutional bank traders, long money and hedge funds all positioned in the same way and then heading for the exit at the same time, you see very sharp moves,' Fulton says.

The volatility has thrown up opportunities for equity investors, Hatherly notes, particularly as performance has been so divergent between different markets and sectors. He says the most bombed-out markets, such as Europe and Japan, saw the largest rises during this month's volatility.

'We have been taking advantage of good stocks offering outstanding value, but selling out of existing positions into the bounces, rather than putting new money in. The end of the first quarter is now approaching and people will be looking more to the comments companies make rather than the actual results,' he notes.

Fulton has been less active however, since closing out his long position in short dated UK government bonds. He notes the latest dip has reversed the war premiums that lifted the sector and the current lack of visibility is leading him to stick close to the benchmark. He says the fact US government bonds outperformed UK and European government issuance proved the market was not trading on fundamentals but reacting to war-related news headlines.

James Phillipps

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