SINGAPORE (Feb 20): Sharp movements in markets have been a wake-up call for complacent investors, but this should not have come as a surprise, says Lombard Odier Private Bank in its CIO Viewpoint February report.

The normalisation of monetary policy brings challenges to financial markets and 10 years after the Global Financial Crisis, economies are starting to stand on their own two feet again, says CIO Stéphane Monier.

"It may not feel like it for many investors this month, but volatility is the market’s friend," says Monier. In fact, corrections of the kind investors saw in the early days of February perform several useful functions.

First, they allow investors to revisit valuations that have been lifted by a rising tide; second, they act as a reminder of the advantage of prudence and long-term thinking and third, "they moderate those ‘animal spirits’ that the economist John Maynard Keynes identified as the dark heart of financial markets," says Monier.

Monier says investors must remember the world has emerged from an era of unusually low volatility. The gains that were seen in 2017 is not the normal course of events and it should shock no one that there was a sting in the tail, he adds.

In fact, volatility will likely be a feature this year. That's because the world is still recovering from the GFC and the era of easy money that followed.

As central banks in the US, Europe, and maybe Japan, step away from accommodative monetary policy and remove liquidity, then markets will tend to "over react", says the CIO.

Nevertheless, Monier believes the macro and micro fundamentals remain firmly in place. Recent growth data have been robust and in line with the broad-based improvement observed over the past six months.

Chinese survey data were generally strong even though some slowdown was expected. The US earnings season has also kicked off in good health. With more than half of companies having reported, 80% of firms have beaten earnings per share estimates and the same number have raised guidance.

US consumer price index (CPI) beat expectations for the second month running, but investors were far more muted in their response than we saw at the beginning of February. This was a clear sign that markets may finally have priced in the prospect of higher inflation, says Monier.

As a result, Lombard Odier is dynamically adapting portfolios to shield its clients from increased market volatility. Its investment managers are suggesting higher exposure to convertibles, which tend to do well in just such an environment.

As debt instruments which can convert to equities under certain conditions. This means they can contain the equity drawdown thanks to their bond floor, but can still gain from much of the upside in stocks. "And from the increase in market volatility which raises the probability of equity convertibility," says Monier.

In January, Lombard Odier also started a long exposure to the JPY against the US dollar (USD) as it believes it is an undervalued currency in a confident economy and with significant upside in the case of any further strong sign of monetary policy tightening.