F&C's Paul Niven comments on market volatility

Paul Niven, Head of Asset Allocation at F&C, comments on the current volatility in markets: "Following the relative calm of April and May, financial market volatility spiked up in June and July towards levels last seen in the beginning of 2003. Renewed fears over the deteriorating outlook for the sub-prime US mortgage market led to a broader reassessment of credit risk, mounting concerns surrounding the potentially detrimental effect it could have upon the financial system, and concern over the wider economic impact of a 'credit crunch'. Corporate bond markets came under serious pressure, with moves in credit derivatives making daily headlines with spreads on these products literally going "through the roof" (with credit default swap spreads more than doubling in July), as holders of the underlying physical debt rushed to hedge their positions. The volatility in credit markets eventually spilled over into equities as banks struggled to sell bonds to finance high profile private equity deals, and concerns grew that the problems in select hedge funds may well become symptomatic of a wider risk to the financial system.

Similarly to the situation back in March 2007, we see the market fears for the sub-prime problems spilling over to the rest of the economy as justified, but overdone. We expect any problems that do exist and are serious, to be well contained. We have been in an extremely supportive environment over the past four years from a credit perspective, considering the low level of interest rates, double digit earnings growth, and overall strength of the corporate sector, and arguably the credit cycle has now turned. Given the robustness of the corporate sector, however, we expect a normalisation of earnings growth rather than anything more severe, and coupled with the relatively low gearing of balance sheets, expect a stabilisation of the corporate bond market rather than a full blown 'credit crunch'. Nevertheless, short-term volatility is likely to persist as uncertainty levels remain high, and market moves are exacerbated by the low liquidity that characterise the late summer/ early autumn months.

The rise of leverage in the financial system over the past few years brings with it the increased probability of systemic risk, and whilst we remain cautious over the near term volatility, we expect the fundamental backdrop to again drive financial asset prices as we progress through the rest of the year. The economic environment, both from a growth and inflation perspective, combines with solid corporate earnings to create a supportive fundamental backdrop for equity markets. We expect this benign backdrop to limit the downside in equity markets, and coupled with the lack of any signs of mania or complacency in equity market valuations will enable equity markets to make solid gains as we progress through the second half of the year. Furthermore, the lower bond yields over the last month (driven by the flight to safety), provide an extra cushion for equities and other risky assets. In short, whilst we are at a more mature phase of the equity bull market, it is not over. As the bull market continues, however, and we progress through the macro-economic and earnings cycle, volatility will continue to rise, and these periods of consolidation will become more frequent. The favourable valuation case for equities remains, but as the bull market matures, it becomes less clear cut, and risky assets are increasingly likely to be driven by short-term news, themes, and dynamic factors than long-term fundamentals and value."