Investors shouldn’t write off another sharp decline in equity markets akin to August’s ‘Black Monday’ given the huge price swings which have affected indices over recent weeks, according to City Financial’s Mark Harris, who says a lack of liquidity and a herd-like mentality among investors are large concerns. 
Recent months have been characterised by high levels of volatility within markets, with substantial falls thanks to China’s slowing growth, weaker than expected economic data in the west and general uncertainty putting pressure on equities around the world.
The largest of these falls occurred on 24 August, which was quickly dubbed ‘Black Monday, when the devaluation of the Chinese yuan and poor manufacturing data out of the world’s second largest economy sparked one of the worst sessions for stocks since the global financial crisis.
Performance of indices since August 2015
Source: FE Analytics
However, as the graph above shows, most indices have recovered those losses – albeit with a huge amount of daily volatility.
Many commentators, such as Royal London’s Trevor Greetham, say that given the selling was largely indiscriminate and the uncertain backdrop has meant the US Federal Reserve kept interest rates at their rock-bottom levels, investors should expect those gains to continue over the shorter term.
However, Harris – head of multi-asset at City Financial – is preparing for further falls as investors are all moving into the same assets at the same time when new economic data is released.
“I’m very concerned,” Harris (pictured) said. “Yes, it really worries me that markets can just go down almost in a vacuum. It’s very easy to explain though, isn’t it? If investors are all crowding into one position and it starts to give way, they just all move over to another trade.”
“You’ve also got momentum traders who follow it, you’ve got this risk parity hedge funds that have to then reduce exposure and probably flip from equities to bonds or a defensive currency while at the same time the banks are now allowed to hold less inventory and so liquidity isn’t as good.”
“It means you just get these big gaps. Has it gone away? No, I think it is still very evident. Is liquidity poor? Yes, I think it is poor. Am I worried another event like that [Black Monday] could happen? Undoubtedly, yes.”
“If it was going to happen I would expect it to happen over the next couple of months. If not, it would happen when or if the Fed raises rates.”
A number of other managers have warned about the implications of the recent price swings in markets, with Coram’s James Sullivan arguing that the market was similar to one presented to investors prior to the global financial crisis of 2008.
Performance of indices in 2008
Source: FE Analytics
Harris’ central case isn’t another financial crisis, however, but he does expect further losses over the short term.
“No, there is not some systemic risk that will result in some bloodbath where equities fall 50 per cent in a very short shift. I’m saying, there could be an air pocket coming up and I think there is pressure on equities.”
“I think earnings could be under pressure and that growth is the only thing that will bail out what are fairly expensive valuations [in the US] and that if you don’t have that growth, then valuations have to come down which means equities fall.”
“Now, whether there is a violent episode is another thing. You’ve got to have a major catalyst for something like that, but I’m not ruling it out so we have tail risk hedging within the portfolios and we are going to maintain it.”
One of the major reasons why Harris is keeping his hedging strategies in place is due to developments within western economies and large parts of the corporate sector.
He says it is concerning that while many expected a rate rise in the US (and even the UK) before the end of the year, recent job data out of the US was weaker than expected and UK PMIs haven’t painted the rosiest of pictures.
By extension, he is also worried about a marked slowdown in corporate earnings.
“US companies, for example, have enjoyed very healthy profit margins and if they start to erode and you’re not seeing top-line growth, we are at a very real risk of earnings coming down further. I wouldn’t say this is my central scenario just yet, but I’m rather concerned that we might be facing an earnings recession.”
He added: “US equity markets are not priced for a marked slowdown in earnings.”
All told, he says the “massive question” which needs answering is whether or not the recent volatility is just a correction or the start of a prolonged bear market, which certain commentators have said is the case.
“Global equity has passed an inflexion point. The bull market is over. For the moment, let us not argue about the causes … global equity, led by Wall Street, is giving clear and classic signals that the post-March 2009 bull market has run its course,” Hawksmoor’s Jim Wood-Smith said last week.
Harris admits he has no idea whether a bear market is on the cards, but he urges investors to remain vigilant and selective.
“If I was going to go for a bear market, I would have to think that the US was tipping into recession and I’m not there yet. The reason for that is because the consumer is still keeping things going, we’ve seen a marked pick-up in construction activity and the housing market is not too bad.”
“Now if for any reason we start to see lay-offs and job losses increase (which we have seen some signs of) and consumer confidence wane then the recession that no one is predicting is on the cards. There is a risk of that and if that was the case, that would turn from a normal correction (as we stand now) into something much deeper.”
“We are in a world where that risk is not priced in most developed markets and, in particular, not in the US.”
Harris, who previously ran funds of funds at New Star and Henderson, joined City Financial in January 2013.
According to FE Analytics, he has outperformed his peer group composite with returns of 16.49 per cent over that time and one of his best relative performers has been the £90m City Financial Multi Asset Diversified fund, which is second percentile in the IA Mixed Investment 0%-35% Shares sector.
Performance of fund versus sector under Harris
Source: FE Analytics
Given Harris’ views on the equity market, growing deflationary impulses and his concerns about slowing growth, he has been adding his exposure to bonds – which is very different to his view at the start of the summer.
While he is very cautious on US equities, he is optimistic on European and Japanese equity funds (he currently holds the likes of Schroder European Alpha Income and Legg Mason Japan Equity) given the very loose monetary conditions within those markets.
He is also considering changing his UK exposure, which is currently geared towards mid and small-caps which have performed very well, given the huge falls in certain areas of large-cap land. He is considering buying an ETF as a result, which FE Trustnet will take a closer look at later in the week.
