What we are witnessing is a struggle in the market between deleveraging and value-at-risk selling competing with decent economic fundamentals and continued central bank support. For now, we believe the positive factors will win out. But market shocks of this magnitude have the potential to overpower fundamentals so we need to remain vigilant.
After months of low volatility, a sudden spike has driven up the calculated risk in many strategies as heavy losses lead to a reduction in desired market exposure. Market moves compelled other investors to exit overcrowded consensus trades. This was illustrated by heavy selling of the dollar — a popular overweight position that has been profitable for much of the year. Normally the dollar would be expected to rise during periods of risk aversion. Gold, another safe haven asset that would typically benefit from market angst, was also down.
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We take the selloff very seriously as this unfamiliar mix of emerging market uncertainty, deflationary pressure, central bank interference, and extreme volatility is hard for global markets to digest. The violent intraday moves of the S&P 500 have likely left many day traders with losses on the long and short side. At the same time, the continued volatility out of China means that it is very difficult to predict where markets will open, let alone trade over the next session. We want to let the forced selling run its course and see some confirmation of our positive economic picture before adding to risk exposure. While it remains our view that risk assets will end the year higher, we are closely watching for any signs that the current market turmoil is beginning to impact the fundamental case for risk assets.
Despite disappointing manufacturing survey data from the U.S. and China over the past week, we remain confident of the underlying strength of the main developed economies. Consumer demand in the U.S. is being supported by robust jobs growth, low inflation and a strengthening housing market. Purchasing managers' surveys, though slightly weaker than expected, continue to point to an expansion. The euro-zone economies are being helped by a combination of cheap oil and aggressive monetary easing by the European Central Bank. We also still believe that the Chinese authorities will succeed in averting an economic hard landing.
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Unless market turbulence undermines business sentiment, the earnings outlook is also positive for our favorite markets. We expect earnings growth over the coming 12 months of 12-15 percent for the euro zone and 10-14 percent for Japan. The second quarter supports this optimism.
The recent extreme market moves underline the merits of a fully diversified global portfolio, with a full range of risk profiles. For those who entered this period with the appropriate level of risk, we believe this is the wrong time to cut back on risk assets. Solid economic and corporate fundamentals are likely to reassert themselves, leading to higher equity values in the future.