FT columnist David Stevenson, writes for Glint on the real winners from the stock market’s recent eruption of volatility, pointing to commodity based emerging economies and telling us to watch the FX canary
Calling all cave dwellers: the great moderation is over and volatility is back in business. Without wanting to sound a tiny bit smug, can anyone really have been surprised that volatility measures such as the ‘Vix’ (tracking the CBOE index based on S&P 500 equities) shot up over the last few weeks?
The last time we saw measures for the Vix move into single digits was back in late 2006 and early 2007 – and we all know what happened next. So, in simple terms, anyone who was still short (betting against) volatility and the Vix was probably playing with fire. Cue the entirely unsurprising news that a number of US volatility products have now ‘blown up’. In fact, the CBOE’s own Volatility Index soared three-fold in just three days as $3 trillion was wiped from equities amid signs the U.S. economy could be overheating. And what started in the US has also hit other developed world markets – the VFTSE (the FTSE’s volatility index) went from under 10 to peak at over 23, while the VSTOXX (the Euro Stoxx volatility index) also shot up to 35.4 from a low of 11 last month.
What went wrong with the supposed great moderation which would see the S&P soar past 3000? The trail of breadcrumbs was always clearly on display…
One of the primary supports for equities over the last decade has been accommodative monetary policy and low interest rates. This has allowed debt levels to carry on increasing – in fact there has been $72 trillion ($72,000,000,000,000) of new debt created since 2008, taking global debt to over 327% of GDP. But that extra liquidity has also supported share prices. So, when interest rates started to increase – helped along by worries about resurgent inflation – it wasn’t any surprise that we saw market volatility.
The only surprise was why anyone thought it wouldn’t happen. A good summary of where we had got to came from risk analysts at CheckRisk who observed that: “In January equity markets globally had become extremely overbought, both on a valuation basis and also from a technical perspective, with relative strength indicators (RSI) of greater than 90 recorded. These are at the absolute upper bounds of what we have seen.”
So why now, early in 2018? What made investors panic in February? One easy way of explaining the mayhem is to focus on the nice round numbers beloved of investors. Take long-term investment returns from risky assets. A huge variety of research studies have shown that most of us expect returns of around 6 to 7% per annum over the long-term from investing in equities. It’s a similar story for dividend yields for equity valuations. Most of us have an instinctive understanding for what constitutes poor value: where price to earnings (PE) ratios shoot past 25 and then 30. And what constitutes good value: anything with a PE below 15.
Given this fetishisation of numbers, it won’t come as a great surprise to learn that bond investors also have ‘magic numbers’ which they think constitutes an important signalling mechanism. The yield on US Treasury bonds is one such example. Most assume that anything above 2.5% for ten-year “govies” constitutes an important turning point, while anything above 3% strikes most as a big flashing red light. One investment bank recently headlined an email to investors with “Is there life at a US Treasury yield of 3%?”. The implication being that any yield above 3% implies that equities might steadily collapse in value. The chart below shows that those concerns are bound to grow over the next weeks and months – yields look they are set for a challenge at 3%.
[caption id="attachment_11533" align="alignnone" width="730"]
US Government Bond Yields[/caption]
Nevertheless, a recent report from analysts at Cross Border Capital does give us some perspective. They published a cracking chart which showed G4 yields (UK, US, Japan and Eurozone) over the last thirty plus years. The current upturn barely amounts to more than a tiny uptick, an almost invisible blip, compared to long-term averages. If bond investors are worried about rising yields, their worries have only just started if history is anything to go by.
Overall though, the prognosis is grim for bonds I suspect. Cross Border reckons global bond markets will suffer a “tough 2018, with G4 markets losing an average 5-6%, and with losses concentrated in US Treasuries and Japanese Government Bonds…. We continue to expect ten-year bonds to test 3.5% yields this year”. If Cross Border are right expect more stock market volatility as first that 3% US Treasuries yield barrier is breached and then 3.5%. If that is the case, expect equities to be about as serene as a white water rapids instructor with a broken paddle up the proverbial creek.
The next breadcrumb on our trail of destruction involves those lovable rogues over in the FX markets. Many years ago, I remember having coffee with a wizened old investment academic who gravely intoned: “David, always watch the FX markets. Everyone focuses on stock indices and bond yields, but the trouble usually starts with FX rates”.
His argument was simple. As the world globalises and becomes more inter-dependent, the interplay between the main currencies – the dollar, euro, Japanese yen and increasingly the Chinese remnimbi – tells you everything you need to know about capital imbalances and the direction of the global economy. Eventually, the widely followed rates, interest rates and inflation rates start to give us signals about those capital imbalances. Asset classes also react accordingly with commodities especially sensitive.
So, it’s with those wise words ringing in my head that we approach the elephant in the room: the weakening dollar. The chart below comes from the US Federal Reserve and shows the trade weighted value of the dollar. Do you notice anything about the direction of travel since the beginning of 2017? You guessed it. Since the start of 2017, the dollar has been falling again. Inflation expectations are on the rise slightly, as are inflation rates (compared to consumer prices during the 2015-16 downturn). Commodities are up, including West Texas crude oil.
Again, it doesn’t take a genius to work out why this might be happening – read the US President’s own words. Trump last year said that while a strong dollar “sounds good”, his actual view on this issue was that “our dollar is getting too strong…it is very, very hard to compete when you have a strong dollar and other countries are devaluing their currency”.
[caption id="attachment_11534" align="alignnone" width="860"]
US dollar index[/caption]
The titanic battle is a clash between two world views: getting a weaker dollar and damn the inflation expectations or unleashing the inflation hawks in the central banks and getting sharply higher interest rates. My money is on the former, especially given the fact that the new Fed chair seems a very long way indeed from being a Paul Volcker – i.e someone who will hike interest rates sharply to kill inflation dead. If he did, it would crush Trump’s (and the Republicans’) re-election prospects overnight.
Assuming all the cynics are right, the chart above indicates that we could see more dollar weakening in the next few volatile months – with a decline of another 5 to 10% on the cards. If that was the case, the asset class implications are clear. A weak dollar is bullish for oil prices: much higher oil prices could be the big surprise in 2018. And remember that every major episode of galloping inflation since 1973 has been fuelled by a surge in oil prices. Emerging market economies are also likely to benefit from a growing influx of capital as the dollar weakens. Lastly, historically at least, there is an inverse correlation between the U.S. dollar and gold.
Riders on the storm
All of which brings us nicely to the possible investment payoff: expect more volatility but also gains for emerging markets and commodities. Again, not that that conclusion should come as any surprise at all – commodities, for instance, have been booming. During the second half of 2017, commodities overall posted a scorching 18% return, making them the best performing asset class.
Analysts at Goldman Sachs foresee what could be called a virtuous “3Rs” scenario, with emerging markets the biggest beneficiaries. “Strong demand growth against limited supply growth due to OPEC and Chinese supply curtailments created significant reflation
in commodity prices last year,” say the Goldman analysts.
“Given the high level of debt held by commodity producers, not only do higher commodity prices reduce the number of bad loans and free up capacity on bank balance sheets, higher commodity prices also help strengthen emerging market (EM) currencies and weaken the dollar via the accumulation and recycling of rising excess savings. On net, this in turn lowers EM funding costs and leads to EM releveraging
. More EM leverage leads to more EM growth reconvergence,
reinforcing even more synchronised global growth and, ultimately, reflation pressures – creating a feedback loop”.
[caption id="attachment_11535" align="alignnone" width="712"]
Goldman Sachs' '3Rs' feedback loop[/caption]
I find this analysis fairly convincing but for now we’ve got to deal with more immediate consequences. Will the market volatility persist, or will we see a more robust bounce back? It’s certainly worth watching so-called “Volatility Control” and “Risk Parity” funds which target a specific level of volatility. According to Bloomberg, this could unleash some $225 billion of equity market sales. Also, some $500 billion of global funds are attached to such strategies and in many cases are driven by algorithms. Such a wave of sell-offs could keep market volatility high at best and could cause a crash if volatility continues to rise.
My own sense is that we are probably experiencing another variant of 2013's Taper Tantrum. The markets know that interest rates will rise but they’re signalling that they think rates shouldn’t rise too aggressively. Maybe they’ve underestimated the steely resolve of the central bankers to crawl back towards monetary ‘normality’. On the other hand, perhaps too much volatility will scare the central bankers back into a more cautious stance. Who knows!?
My own guess is that if the FTSE 100 finds itself under 7000 – and the S&P 500 under 2400 – I’d probably think about venturing back into the markets. Whatever target level you have, I’d observe that a consensus view is beginning to crystallise: long (bet on) emerging markets versus some developed markets, caution on the US, short bonds and long some commodity trades.
David Stevenson writes the Adventurous Investor column for the Financial Times, for whom he has also written several books. He is the editor in chief of AltFi, has previously worked for the BBC, ITV and Channel 4 and has advised a number of firms on investment and communications, including HSBC and EY.