Edison Investment Research

Volatility spike: Investors have only themselves to blame.

The only mystery is why markets were so placid in the first place

Perhaps controversially, we view the intellectual horsepower being consumed by the legions of writers commenting on every second’s movement in markets over the last few days not dissimilar to the wasted electricity consumed to validate speculative bitcoin transactions. Both activities are in our view of relatively modest economic value, even if there is currently heightened demand. There have been, in a historical context, only modest declines from the highs for major stock markets, albeit concentrated in the stronger local currency year to date performers of the US and Japan. In volatile times, investors must remain focused on the long-term outlook.

Canaries in the monetary coal mine?.

High profile difficulties in a hot corporate debt market are intriguing

Steinhoff and HNA Group are from different regions and sectors. Yet they are making the headlines for the wrong reasons as the market raises questions over their debt sustainability. What these firms do have in common is that have pursued a policy of debt-financed acquisitions during this cycle. Now, LIBOR rates are pushing markedly higher. These signals of tightening credit bear watching in our view, even if they are presently not a cause for immediate alarm. It is however our important to be alert to early signs of a turn in credit availability. This is likely to first occur at the margin of the credit risk spectrum, as in 2007/8.

Government bonds in the firing line.

The next twist in the story is likely to push global yields higher

It is always important to put aside preconceptions and let all the data speak – and not just that which confirms prior beliefs. At present, the data which best models the long-term outlook (valuations) are suggestive of relatively weak returns in global equities and this has informed our cautious positioning. Furthermore, bond yields and interest rates remain unusually low on a historical basis. Yet for the short-term, economic surprises are currently positive, business sentiment strong and profits growth relatively robust. It is this short-term data which also needs to be heard.

Interesting times for central bankers.

If growth is picking up, why are bond yields still so low?

It appears the low volatility/high valuation regime in equity and credit markets is continuing into the autumn. This is despite an important and imminent US Fed balance sheet reduction announcement. Furthermore, October brings details of the ECB’s plans to reduce the net purchases of its own QE program. While central bankers are quick to claim credit for any improvement in economic conditions, the decline in long-term bond yields over the summer questions the durability of the expansion as the yield curve flattens. It also remains to be seen if investors will re-appraise the low level of risk premia in global markets as QE is withdrawn.

Volatility: Low, but downside protection in demand.

We struggle to understand why market volatility has fallen so far in 2017

One of the notable aspects of equity market performance during 2017 has been the rapid fall in market volatility. Trailing 90-day realised volatility for the S&P 500 has reached 7% in recent weeks. Over the last 20 years, these are levels are matched only during a brief period over 2005-2006. We do not see an especially strong parallel with 2005 as at that point US equities were still moderately valued and the US economy was expanding after a mild recession. We believe investors are once again becoming complacent; but also note the skew towards higher priced put options suggesting within the options market at least that downside protection is at a premium.

Just what the Fed wanted.

A rate increase and a rising market – but was it really dovish?

Having primed markets to fully expect a US rate increase, the FOMC followed through on the 15th March. If the aim was to deliver a rate increase without abruptly causing tighter financial conditions (code for declining equity and credit markets), then it was mission accomplished. Following the FOMC announcement the dollar eased against other currencies, bond yields fell and equity markets gained. However, despite comforting language within the statement we detected a more strategic, rather than data dependent, direction for US interest rates in the press conference Q&A.

C’est l’économie… French and German bond yields diverge.

It’s not the unlikely election of Le Pen, it’s the economy ...

The recent divergence between French and German government bond yields has been widely attributed to a possible victory for the anti-euro Marine Le Pen in the French presidential election. In our view this is not the whole story. The widening gap in terms of borrowing costs also mirrors the increasing economic divergence between France and Germany. Therefore, the increased risk premium for French government debt should be expected to persist, even after the election of a mainstream candidate, adding to pressure on the euro project.

Trump’s double surprise.

It is quite clear that in the days leading up to the U.S. Presidential election, both markets and surveys got it wrong. Traditional polling once again failed to spot the depth of support for radical political change. This was after all the U.S., which has delivered the strongest post-crisis economic performance of any developed nation. 

BOE: Bank on track.

Today’s BOE decision represents a correction in UK policy makers’ thinking. The sudden stop in activity which was implied by the Bank’s August stimulus package has not materialised and the focus has instead returned to significantly above-target inflation by 2018. This is going to be supportive of sterling, especially as consensus views on the exchange rate had become so negative.

Equity valuations – party like it’s 1999… and 2007?.

Amidst something approaching a euphoric relief rally in global markets following the UK’s vote to leave the EU, investors should not overlook equity valuation metrics, which have historically provided an excellent guide to returns over the long term. As Exhibit 1 shows, relatively low valuations preceded the bull markets in 1994-1999, 2002-2007 and 2009-2013. However, valuation metrics rarely form part of a market narrative and if they feature at all are often dismissed, usually as “it’s different this time”.

ECB - Using the bazooka.

With survey data pointing to a marked slowdown in the eurozone manufacturing sector, Exhibit 1; forward inflation expectations at 1.4% significantly lower than at December’s meeting; and a cut in the ECB’s projections for economic growth from 1.7% to 1.4% for 2016, anything other than a forceful response would have been received very poorly by markets. This would in our view also have been tantamount to a policy error. But unlike December, this time markets got what they wished for – an increase in the size and composition of eurozone QE.