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Outlook May 2018: The importance of diversification

The extended US sanctions against Russia in April caused the Moscow exchange to slide by around 15 percent in two days. This large market movement wiped out the strong performance of Russian stocks earlier in the year. The rouble also plummeted. We are reminded once again of the importance of diversification and not taking too much risk.

The turbulence escalated after the United States extended sanctions against Russia. As a consequence, the risk premium for the Russian market has risen, but strong oil prices have partially alleviated the impact. The price of oil has risen steadily during the year, and there is much to suggest the strong trend will last for a while. The dollar is usually negatively correlated with oil prices, so a strong dollar normally means pressure on oil prices and vice versa. However, there are exceptions and periods when this relationship does not apply. For example, the correlation between the dollar and oil prices was relatively weak in the late 1990s.

The price of oil has risen steadily during the year.

The current situation, with strong shale oil production in the US that caused US oil imports to fall by about 30 percent from the peak of 2005, probably means that the dollar/oil correlation will again weaken. The dollar has strengthened by 3 percent since the end of January, and during the same period Brent oil has risen by 9 percent. Demand for oil is strong and OPEC/Russia’s production constraints are affecting oil stocks and supporting oil prices. A price in excess of USD 80 per barrel this year would not be unrealistic.

Sweden: A weakened krona.

The overall PMI dropped for the second month in a row, showing a continued slowdown from high levels. The index fell to 54.5 in April from 55.9 in March. The sub-index for new orders contributed most to the overall decline. The Economic Tendency Survey from Sweden’s National Institute of Economic Research showed strength and increased by 1.6 points in April to 110.4, after falling for four consecutive months. The level points to much stronger sentiment than normal.

The krona continued to weaken this month and lost 5 percent against the dollar and 3 percent against the euro. As expected, the Riksbank left its repo rate unchanged at its last meeting, at -0.5 percent. It also stated that a first increase will only take place towards the end of the current year, which is a postponement from its previous stance. This announced postponement from Riksbank Governor Stefan Ingves led the krona to lose more ground. Ingves says we should expect the krona to move up and down because we have a variable exchange rate and that the Riksbank has no target for the currency.

 

The krona continued to weaken this month.

Whether a weakened krona is good or bad remains to be seen. The Riksbank chief is stubbornly holding on to the 2 percent inflation target, but the question is whether the krona may have weakened more than they expected.

USA: Still strong.

The US economy is still showing strength. Unemployment fell to 3.9 percent in April, which is the lowest figure since the end of 2000. But surprisingly, wage increases are still low despite falling unemployment. During the month, 164,000 new jobs were created, against the expected 192,000. The figure was slightly lower than expected, but it may well be revised.

The Purchasing Managers’ Index for manufacturing industry in the US dropped to 57.3 in April from a very high level of 59.3 the previous month. And the US ten-year interest rate rose to three percent this month, which is a five-year high.

Europe: Volatility has returned.

Germany is showing further signs of slowing from high levels. The IFO index, which measures Germany’s business climate, fell to 102.1 in April, compared to 103.3 the previous month. With the latest figure, the index has now fallen for five consecutive months. Both the purchasing managers’ index and the IFO index have fallen, but levels are still high. It is probably too early to conclude that there will be a slower growth rate ahead. But, as always, it is hard to see turning points. The German economy is still showing good wage growth, low unemployment and rising government investment.

The IFO index has now fallen for five consecutive months.

Volatility has returned to world stock exchanges. The large share price fluctuations are leading many investors to think more carefully about how the allocation of their assets will look. An effective way of managing an increased risk is to diversify and spread the risk by owning multiple securities, for example by owning a number of funds. Another way is to invest in several markets, thereby lowering the risk and reducing correlation. A third is to diversify is over time, and perhaps not many investors consider this.

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