Sharp falls in global markets and a surprise drop in bond yields have startled investors. Sentiment is suddenly fragile. What to make of developments? Erik Knutzen of Neuberger Berman gives his thoughts.

After a period when people seemed concerned about the uncanny calm of global financial markets – as reflected by measures such as the US gauge of equities volatility, the “VIX” – all that has ended with several days of sharp falls to global equities, due to concerns about earnings and economic growth in the US, perhaps intensified by realisation that the US Federal Reserve is turning off the quantitative easing spigot.

The S&P 500 Index of US equities shed its gains for the year. The MSCI World Index of developed countries’ equities is down by 2.38 per cent; the MSCI Far East Index is down by 4.9 per cent and the MSCI Europe Index is down by over 10 per cent. Bond yields have fallen, as is often the case when risk appetite tumbles. The VIX Index of equity volatility in the US was last at 27.9 (as of yesterday morning in New York); the average level for the VIX during 2013, by comparison, was just over 14.

Against this background, Erik Knutzen, chief investment officer – multi-asset class at Neuberger Berman, says that while caution is warranted amidst current uncertainty, attractive investment opportunities remain in global stock and credit markets. As ever, this publication welcomes readers to respond.

Financial markets have caught a new case of the jitters, driven by fears of slowing economic growth, particularly in Europe and China. As a result, global stock markets have retreated in a pullback spanning geographies, sectors and market capitalisations. Government bond yields have dropped from already rock-bottom levels. The dollar has soared and the price of oil has tumbled even as conflicts simmer in oil-rich regions. For investors, this has ushered in a new phase of uncertainty, upsetting the “Goldilocks” scenario that has for some time provided confidence in financial assets.

We are cautious regarding markets in the near term as we see a number of risks continuing to haunt the environment in the weeks to come. Inflation and economic growth in Europe remain quite low, and we wonder whether the European Central Bank will do enough to get things moving again. Japan is at a critical juncture in the progress of “Abenomics,” with evidence of economic growth needed to provide support for key reforms. In China, investors are assessing lower expectations for growth in the midst of a property market correction and concerns about a credit bubble. And the rising dollar and reduced global growth outlook are sending commodity prices lower, raising concerns around commodity-exporting emerging markets.

Geopolitics have been a dizzying force this year, with new conflicts arising regularly. Thus far, however, we feel their economic and market impacts have been limited. Among the key situations to watch:

-- Iraq/Syria: The terror group ISIS appears on the verge of taking a key province bordering Baghdad. However, despite the group’s territorial gains, oil markets have priced in a low probability of supply disruption - actually declining due to growth concerns.

-- Hong Kong: Pro-democracy protests have been ongoing for two weeks, causing significant business disruption in this key city. The government appears unlikely to give in and seems to hope that fatigue and pressure from public opinion will cause protesters to back off. Despite worldwide attention, we don’t expect the situation to affect markets over the longer term.

-- Ukraine: Headline risk from Ukraine/Russia has eased since the ceasefire last month, and the report of a Russian pullback from the Ukrainian border appears to reduce the risk of invasion. Presidents Vladimir Putin and Petro Poroshenko both have incentives to ease tensions, as shown by their willingness to meet in Milan next week.

Volatility and opportunities
“While there is potential for ongoing financial market unease in the near term, we believe that the current volatility may be creating buying opportunities, particularly in the area of US equities and in emerging stock and bond markets. We have a more neutral stance in Europe and Japan where we want to see how policy actions unfold both from central banks and fiscal authorities.

Supports for US equities
“In the US, two key supports remain in place - accommodative central bank policy and steady corporate earnings. [Fed] FOMC meeting minutes reveal a more dovish posture than many anticipated, reinforcing the idea that future rate hikes will be data-dependent. With respect to corporate earnings, investors will be inundated with third quarter results over the next few weeks. There may be more downside risk here, given somewhat weaker recent macro data and uncertain impacts of the strong dollar. One potential positive for many sectors is lower oil prices, as Brent crude declined 16 per cent in the third quarter.

“Overall, we believe companies have been effective in navigating a challenging environment. Another strong earnings quarter would give investors the opportunity to refocus on fundamentals and provide stability to financial markets. US small-cap stocks have been particularly challenged this year, and valuations have come way down. If one accepts the idea of economic “decoupling” between the stronger North American economy and weakness in Europe, the small company segment provides exceptional exposure, with 80 per cent of constituents’ sales coming from the US.

Value in emerging markets, non-investment grade
“We also see potential in select emerging stock and bond markets, where valuations are attractive relative to developed markets, economic growth remains robust, and negative sentiment appears overdone. Finally, we see opportunities in non-investment grade fixed income, where spreads have widened but, despite global growth concerns, prospects for defaults remain below historical averages.

Obviously, recent turbulence has been unsettling, but it’s worth mentioning that many stocks have come a long way in the past few years. We view pullbacks as part of the investment backdrop and a factor to be accounted for in portfolios - both in terms of risk management and setting the stage for future opportunities.”