Article first published in The Business Times on 21 August 20243

Buckle up! The extraordinary market volatility of late suggests a white-knuckle ride ahead for investors globally. Quite literally, we are experiencing an end-of-cycle regime change: at the political level, in terms of monetary policy, and – most evidently – in the leadership of financial assets.

In all cases, the ongoing rotation will be hard to predict – possibly chaotic. I would therefore suggest that uncertainty coupled with consequence should be the two highest conviction drivers that guide one’s asset allocation and positioning in the weeks and months ahead.

By their nature, inflection points are almost always accompanied by heightened volatility; and we can see evidence of that in the head-spinning rotation among equities and bonds recently.

It is hard to recall a period in which risk assets have switched so quickly from large to small-caps, from growth to value, or from developed to developing markets.

Momentum in tech stocks – or, more accurately, the tech stocks known collectively as the Magnificent Seven – has taken a hit, erasing close to US$1.5 trillion of market capitalisation during the Aug 5 trading session alone.

Faced with so many moving parts, where should savvy investors now put their money? I am not sure whether history repeats, rhymes or simply resonates; but experience tells me that when uncertainty abounds, a balanced, diversified portfolio weathers volatility substantially better than alternatives.

Put another way, in fast, uncertain markets, smart portfolio managers will unwind overweight or underweight positions in favour of a market weight position. This is precisely what the investment committee at Lombard Odier did ahead of the recent turmoil.

Read more about Lombard Odier’s playbook for Asia’s currency volatility

Butterflies

Clearly, with global markets in a state of flux, a strategic weight offers some shield against volatility.

The butterfly effect in chaos theory proposes that in an integrated, complex ecosystem, a small change in one state can impart a substantially larger effect on another. This effect speaks to the risk of disruptive, hard-to-predict and unintended consequences.

It also captures the challenge that investors face as they seek to understand and anticipate the web of cause and effect that links the behaviours and performances of the major asset classes.

For example, interest rate expectations that are shifting higher in Japan and lower in the United States have contributed to an extraordinary outperformance of the Japanese yen versus the US dollar.

In turn, the apparent unwinding of the yen carry trade appears to have impacted the performance of both Japan equities and the Magnificent Seven. There was, possibly, a domino effect of margin calls on large levered positions on these assets.

This has accelerated the rotation into US bonds, additionally boosted by growing fears of recession in the US economy.

Whether market conviction around the recession narrative gains momentum depends significantly on the reaction function of the US Federal Reserve –specifically whether it is willing to ease policy in the face of softening in the US employment market.

In my view, the futures market has priced in an unrealistically high number of interest rate cuts for the next 18 months.

Our economists’ reading of current economic conditions in the US suggest such a large move up front might not be needed as the underlying financial health of US households remains robust.

Find out about Lombard Odier’s ambition in Japan

Hopes and fears

Yet, market expectations of such unfeasibly large rate cuts can be partially understood in the context of non-economic risks – namely fears of escalating tensions in the Middle East and uncertainties around the US election in November.

At the time of writing, Iran had not responded to the attack allegedly orchestrated by Israel on the political leader of Hamas; but this fragile calm could shatter easily depending on the scale and proportionality of Iran’s military reaction, triggering a rapid spike in geopolitical risk premia in the prices of assets – especially crude oil.

In the US, latest opinion polls have the two presidential candidates – former president Donald Trump and current Vice-President Kamala Harris – exactly tied, with no clear electoral advantage accruing to either candidate or side.

That gridlock may clear if one candidate pushes ahead and becomes a favourite in the weeks ahead; but in the meantime, uncertainties over the outcome could further confuse markets.

The reality is that it is difficult to guess either side’s policy announcements, content and effects. As much as we’d like to anticipate a preferred outcome, an investment strategy based on hope is rarely credible.

My reading and understanding of the proposed polices of both candidates and their parties is that they differ in relative degrees rather than absolute substance.

Both seem willing to contain and confront China’s economic expansion, albeit by different degrees. Both seem willing to better police their border with Mexico, but differ on the scale of resources required.

There may be some disagreement over whether lower taxes or higher fiscal spending are required to promote growth; but, in our view, Trump’s agenda will be slightly more inflationary between the two due to his pledges on tariff, immigration, and fiscal policies.

Base case

Market volatility has prompted a careful review of our base case. We now expect the Fed to get ahead of the curve at its next scheduled rate-setting meeting in September.

It can do this either by starting the easing cycle with a 50 bp cut – making up for skipping a move in July – or by a 25 bp cut accompanied by strong guidance on the path forward, ie projections that indicate successive rate cuts in the remainder of the year.

Since there is one more US employment report before the September Fed meeting, this is likely to be the determining factor of the precise path of rates.

We now expect the Fed to cut rates at successive meetings rather than on a quarterly basis. A glide path of successive 25 bp cuts suggests that US rates will reach mid-3 per cent in 2025.

While labour market softness is a cause for concern, and a reason for Fed action, I would underscore that the overall picture including gross domestic product, income growth, the shape of private sector balance sheets and employment shows a US economy that remains in healthy shape.

Assuming the Fed does indeed get ahead of the curve – as we expect it to do, given that it tends to be fairly reactive and has made important shifts in messaging already – this should suffice to keep recession risks at bay. We maintain our base case of a soft landing for the US economy.

That said, the potential for chaos and consequence abounds. In such an environment, we firmly believe that a strategic, market weight allocation offers the best balance of portfolio risk and reward.

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