After a less than thrilling summer, since September, equity markets have been relatively immune to news flow on the geopolitical front, despite North Korea’s nuclear threats and the crisis regarding Catalonia, which remains broadly unresolved. We see two main reasons for the uptick in equity market performance:
1) the pro-European axis led by France and Germany is still strong and appears to be a potential backstop for further deterioration with regard to the situation in Spain, which is not, in our view, a systemic risk for the Eurozone; and 2) in the last quarter of this year, we expect to see a renewed focus on market fundamentals. The benign growth scenario and the positive momentum for corporate earnings should continue to be supportive for equity markets, though we acknowledge that we are moving towards a more mature phase of the cycle. On fixed income, this “back to fundamentals” framework is driving a rebound in interest rates from year-to-date lows. In this context, we continue to maintain a cautious view on duration and a constructive approach on risk assets, especially equities. However, we believe that the extraordinarily low volatility regime that we are currently experiencing (in the last three years, a daily reading of the VIX below 10 has occurred 4% of the time, compared to a 0.6% incidence from 1990) will be challenged moving into 2018 by a number of factors: the ongoing monetary policy normalization; the economic cycle moving towards a more mature phase (where this transition will likely not be linear); a revival of inflation expectations from extremely low levels (potentially surprising on the upside); and unforeseeable geopolitical developments which are not fully priced into the market at this time (eg, Brexit, North Korea). The expected transition will require, in our view, a risk rotation in 2018, with a cautious approach on the most complacent areas of the market (ie, credit, momentum trade). In the meantime, we believe investors should focus on quality and an efficient use of hedging strategies to help to mitigate market risks.