Global investors are starting to cut back on stock market positions, wary of a wave of financial market turbulence in the final quarter of 2014 as the era of cheap money ends.
The tide turned abruptly this week with the close of the third quarter and major stock markets have lurched down at the start of October, a month associated with previous market shakeouts including the 1929 and 1987 crashes.
Two weeks earlier, the benchmark S&P 500 index reached an all-time high, prompting many investors to speculate that shares were too expensive by most historical measures. Since reaching that peak on September 19, Wall Street has dropped nearly 4 per cent and many expect more volatility to come.
"The last three years have been quite good for equities but now it's going be a lot harder. Unfortunately you've now got to invest with seat-belts on... You have to accept more volatility. We expect the next six months to be very challenging," said Remi Ajewole, a multi asset fund manager at Schroders, one of Europe's largest independent investment groups.
Markets are starting to price in the US Federal Reserve calling time on the easy money policies which it brought in as economic life support after the financial crisis of 2008.
Quantitative easing, a pillar of this policy which involved the Fed buying up bonds to add liquidity to the financial system, is due to end later this month.
A second aspect, keeping official interest rates in the United States at historic lows, is also expected to end within months as the world's largest economy strengthens.
The prospect of a relative scarcity of US dollars has driven the currency higher in recent weeks. While this may seem a benign development to American consumers who see their international purchasing power increase, it is proving disruptive to financial markets.
A new period of dollar strength risks drawing American investment back home, fearful of heavy currency losses on overseas assets. This in turn can affect US corporations because it devalues their overseas earnings in dollar terms and risks making American exports less competitive.
Charles Morris, London-based head of Absolute Return at HSBC Global Asset Management, said the currency market was going through one of its phases when a decisive dollar move pushes everything else in the opposite direction.
"Every single currency is going down except the dollar which is shooting up like a rocket. It's like a water bed with a big fat man on it," he said.
Morris said he has been reducing risk before the last quarter, cutting back on equities, high yield credit and emerging market debt while adding dollar assets which he calls "the number one defensive thing you can do".
However, some investors point to a risk that the end of cheap money could affect smaller US companies.
"In the US we are very sensitive to small cap stocks. We think they were the primary beneficiary of QE and in an environment where the Fed turns off the liquidity taps, they could struggle," Ajewole said, adding that while her Schroders team still regards stocks as "a good asset class", she has reduced exposure.
A Reuters poll of investment managers around the world published on September 30 found a sense of caution manifested in people putting their biggest bets since March on bonds, which are typically regarded as a shelter against market volatility.
ON THE BRIGHT SIDE
Some investors nonetheless say the overall economic outlook remains benign. The Fed raising interest rates is a symptom of robust economic growth, they say, even if it carries risks.
Brian Reynolds, chief market strategist at Rosenblatt Securities, said heavy appetite from pension funds and other institutions for credit means corporate bond sales will remain robust even if interest rates rise a bit. That will help underpin stock markets.
"What we're going through now is a short-term panicky selloff and when it runs its course the credit boom will resume," he said.
Meanwhile, the European Central Bank is going in an opposite direction with easier monetary policy aimed at jump-starting a moribund economy. The Reuters poll found Europeans raising equity exposure, partly on account of optimism for corporate earnings if European companies get access to cheap money.
"For the remainder of the year we expect higher volatility in markets, but still prefer equities over other asset classes," said Boris Willems, a strategist at UBS Global Asset Management.
"Monetary policy overall continues to be accommodative, in spite of some policy divergence over the coming months and years... The OECD (developed) economies remain in expansion."
The VIX index of volatility, known as "the fear index", sits at around 17, up nearly 50 per cent since the end of August. However, it remains about 80 per cent below the peak reached in the crisis year of 2008 after swinging between 20 and around 47 through the late 1990s and early 2000s.
Andrew Milligan, Head of Global Strategy at British fund manager Standard Life Investments, says the rise in volatility belies what should be seen as an opportunity to snap up good stocks on the cheap.
"The underlying trend in corporate cash flow remains positive. The only reason that the US Federal Reserve would raise interest rates in 2015 is because the US economy would be strong enough, demonstrating tighter labour markets and thus reassuring investors that policy tightening is needed to ensure the recovery is long-lasting," he said.
Copyright: Thomson Reuters 2014