As stock markets navigate heightened volatility and rising tensions in the Middle East, Zenith Investment Partners says the challenge for investors is to stay focused on medium-longer term outcomes and building robust portfolios that will deliver on those outcomes. 

“Global stock markets have experienced rapid mood swings recently, flipping between optimism and pessimism, highlighting the fickle nature of sentiment. Headlines have attributed this volatility to various factors including the Bank of Japan's rate hike, the weak July US jobs report and talk of recession,” says Damien Hennessy, Zenith head of asset allocation.

“We should also remember that markets had moved sharply higher over the past year and have been vulnerable to a bout of profit-taking or a correction.

“More recently, tensions in the Middle East have reached new heights as the prospect of direct conflict between Israel and Iran looms large, threatening further geopolitical instability. The US has said it is preparing for what could be significant attacks on Israel by Iran and that it had responded by increasing its forces in the region.

“Momentum plays a significant role in markets but as we have seen, is interspersed with periods of extreme volatility and this creates challenges for investors. Do you respond, cut positions following sharp declines, or take advantage of any opportunities? 

“We are always reassessing our market outlook in light of such events but always through the lens of what these events mean for growth, inflation, bond yields and policy,” Mr Hennessy said.

“For example, the gyrations in the yen and Japanese equity markets in recent times highlighted the role of momentum and leverage in markets, but do they change what appears to be some favourable structural tailwinds for Japanese equities? We take the view that the Bank of Japan will not want to risk years of trying to get inflation and growth higher by lifting rates too quickly. While the yen may not be the momentum trade it was, it is unlikely to cause further violent shifts in sentiment in the near term.”

Other risk areas include ongoing weakness in Chinese growth and any flow-on to the Chinese currency while the US election may also be a source of volatility.

“Volatility is inherent in markets. This year, markets have swung from ‘soft-landing’ to ‘higher for longer/no-landing’ scenarios back to ‘soft-landing’ and just recently, towards a ‘hard-landing’. This reminds us that markets are forward-looking and in an uncertain environment, they are constantly weighing up risks and opportunities, leading to marked swings in sentiment and volatility,” Mr Hennessy said. 

“For investors and advisers, their task is to acknowledge the uncertainty, separating the noise and headlines from the real challenge of building well diversified portfolios that will perform well over the medium and longer term,” he said.

Turning to the US economy, a weaker-than-expected July jobs report raised concerns of a potential US recession. However, a closer look at the data reveals that the rise in the US unemployment rate was partly due to an increase in the labour supply and strong immigration, rather than a large drop in labour demand. 

“The US economy is slowing and we should expect weaker data going forward. While the so-called Sahm rule, which signals a recession when the three-month average unemployment rate rises more than 0.5 per cent from its 12-month low, was triggered in July, a broader range of indicators are not consistent with a recession in the US at this stage,” Mr Hennessy said.

“Other indicators such as consumer spending and business investment are still growing. We still believe the US economy remains on a soft-landing path, which is an outcome of central banks raising interest rates just enough to bring down inflation to their target levels, without causing a major recession or meaningful increase in unemployment levels. 

“While our base case scenario for the US, and indeed for Australia, remains a ‘soft landing’, modest recession is a risk we cannot ignore and this is why we have been steadily increasing our allocation to high-quality government bonds, known for their resilience during economic downturns,” he said.