With plenty for investors to fret about in global markets, there are steps that can be taken to manage increased risk and volatility. 

The tourism slogan for Wellington, New Zealand is “you can’t beat Wellington on a good day” and it is true. When the weather is fine and the breeze gentle, Wellington is a fabulous city to enjoy.

For many tourists however, the unknown quantity is that Wellington lies on a major fault line and experiences many small tremors on any given day.

The largest earthquake to rock the country’s capital was 162 years ago, but scientists believe the region will likely suffer from a major quake every 150 years. So, despite being overdue for an earthquake, the city continues to flourish.

The same can be said for capital markets. After a year of strong returns for major asset classes, and one which was characterised by low volatility and historically insignificant pull backs, investors believe that "the big one" is coming given it’s long overdue.

There is plenty for investors to fret about--most notably that the US economy, the world’s largest, is approaching the end of its expansionary cycle and that earnings could start to turn down. With the richer valuations in the US equity market, an earnings recession could be the trigger for a sharp market correction which would reverberate globally.

A recession would also lead to an increase in corporate defaults and a sell-off in the corporate bond market, which has seen valuations surge to cyclical highs in the last year.

Then there is political uncertainty in the form of potentially more aggressive trade protectionist policies, or central banks that raise interest rates faster than expected. In principle, these are all valid concerns and things that a conscientious investor should be aware of, but are much more debatable in terms of timing.

Take the case of a recession in the US, for example. The current economic expansion has been running for 102 months, making it the second-longest expansion since World War II. But it has also been the slowest.

The protracted nature of the economic recovery in the US, and around the world, is one of the reasons why it can go on even longer as major imbalances haven’t had the opportunity to be created. The correction of an imbalance is what typically leads to a recession.

There are still signs that the US economy can remain robust. Corporate investment is improving and household consumption remains strong. Household spending could be aided further if the US shale oil industry continues to support a stable oil price and the decline in the unemployment rate leads to a long-awaited increase in wages. Meanwhile, there is the boost to the economy which will come from the tax reform package and no doubt increase in government spending.

There is some fear that the narrowing in the spread between short and long-dated bond yields--a flattening of the yield curve--in the US is the first of the early tremors. The shape of the yield curve is worth monitoring given that an inverted yield curve preceded the past four recessions in the US since 1980. But investors should be mindful of the signalling effect of the yield curve. The impact of years of central bank largess and bond purchasing is no doubt having a distorted effect on bond prices and yields.

Moreover, historically there is a lag between the inversion of the yield curve, when the market peaks and when the economy tips into recession. Based on the experience of the last seven times the yield curve has inverted, the average time to market peak was 10 months, and the average time to a recession was almost 18 months.

Beyond the concerns about the durability of the US economy and its importance in global markets, many will be worried that the stellar returns from 2017 can’t be repeated and that the good times are over. 2017 certainly was exceptional in terms of the low levels of volatility, but an increase in volatility itself does not exclude the possibility of investors generating respectable returns. For the more active investors it actually creates opportunities--particularly those with a greater focus on corporate fundamentals and big macro-economic drivers.

European, emerging markets and Asian equities continue to be attractive. Their economic recovery is translating into earnings growth that will extend well into 2018. Meanwhile, fixed income returns are going to be highly dependent on the size of coupons rather than capital gains. Adopting a more flexible approach to fixed income markets and moving away from following traditional benchmarks may be the best path forward. Beyond the traditional fixed income and equity markets, alternative assets and strategies could play a greater role in asset allocation to manage risk and increase diversification.

Despite the clear threat to the livelihood of many Wellingtonians, it remains a great place to live. Last year Deutsche Bank rated Wellington as the best place to live out of 47 global cities (it was also Lonely Planet’s 2017 best destination to drink beer).

Similarly, capital markets remain a great place to invest, even if on shaky ground. The global economic backdrop remains favourable to equities and other risk assets and the increase in volatility can be managed as long as investors follow the time-tested principles of diversification and rebalancing.

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Kerry Craig is aglobal market strategist with J.P. Morgan Asset Management. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

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