At the beginning of February, we were contemplating whether the market was about to hit the buffers, and into the lows we have indeed seen the FTSE 100 fall, by 7.8%, and the S&P 500, by 11.8%. Since then much chopping about, with no as yet clear trend, has been evident. What we can say is that, the pattern so far is similar to the summer of 2015, when we had a week of falling prices and then a somewhat ragged rally which preceded another lurch lower still.
One thing that has contributed significantly to the low volatility regime since 2008, particularly in the US, is share buybacks. The technique “magically” reduces the price-to-earnings multiple as the earnings number does not adjust for the reduced share count. Share buybacks are a major contributor to the low volatility regime because a large price-insensitive buyer is always ready to purchase the market on weakness.
Share buybacks result in a lower volatility/lower liquidity environment, which in turn incentivizes still more share buybacks, further encouraging passive and systematic strategies that are short volatility in all their forms. Like a snake eating its own tail, the market cannot rely on share buybacks indefinitely: to nourish the illusion of growth. Rising corporate debt levels and higher interest rates are a catalyst for slowing down the $500-$800 billion in annual share buybacks artificially supporting markets, and suppressing volatility.
Share buybacks are merely one of the factors affecting the low volatility regime. Apart from strategies that explicitly short the VIX complex (the VIX is the symbol for a traded index that tracks volatility on the S&P 500) there are numerous implicit short volatility trades, many of which are regrettably misunderstood or ignored by investors. Passive investing is one such strategy.
At the start of 2018, according to Bernstein Research, 50% of the assets under management in the US will be passively managed. According to JP Morgan, since the great financial crisis, $2 trillion in assets have migrated from active to passive and momentum strategies. Passive investing is effectively a momentum play on liquidity. Money flows into equities for no other reason than they are members of an index and are highly liquid. With the massive inflows all the stocks in the index move together, regardless of fundamentals. Consequently, the volatility of the whole market can be dominated by a handful of mega cap stocks.
The shift from active to passive is a worrying amplifier of future volatility. Active managers act as a volatility dampener, buying undervalued stocks when the market is falling and selling overvalued stocks when the market is rising. If there is no buffer then there is no marginal seller to control overvaluation on the way up, as we have been witnessing for a number of years, and no buyer to prevent a crash on the way down.
The other volatility trade that has been taken very much to heart without any real understanding of its consequences is the managed volatility complex. As a rule, as volatility increases, risk, usually equity risk, is managed downwards, and vice-versa when volatility falls. Looked at another way, this is akin to selling at the bottom and buying at the top; as back to front as you would ever want to get. Volatility spikes tend to happen when markets correct downwards. This is the nature of the bear: sharp downward movements followed by rapid corrections and then another lurch to the downside. Bull markets grind up relatively slowly and are thus less volatile. As many current investors and fund managers have never seen a proper bear market this cannot of course happen, can it?
What might spark the next large volatility event? (The move in early February is most likely a precursor.) That, “volatility is the brother of credit,” is indeed an apposite quote from Chris Cole at Artemis Capital L.P. When credit is easily available companies can rely on the ongoing cheap debt to support their operations; research and development, capital expenditure and, as we are seeing now, share buybacks. Cheap credit makes the value of equity less volatile. So, a tightening of credit conditions will lead to higher equity volatility. On that front the storm clouds are gathering, with three further rate rises pencilled in for 2018 plus US Treasuries heading for 3%.
We do not currently hold high cash levels, but are, nevertheless, defensively positioned as market volatility has started picking up. How high can volatility go? Since 2008, volatility has barely exceeded the 30% level that we witnessed earlier this year. If one goes back to 1987, however, which witnessed a crash driven by rising rates and inflation, exacerbated by computerised trading, the volatility index hit 150%… you ain’t seen nothin’ yet.
We are witnessing a change in the pattern of equity markets, and the UK is no exception. The long running bull market may yet have another twist in store for us, but an initial correction down to 6600 would only retrace 50% of the move up, from the lows of 2016; hardly the end of the world given that the index was below 3500 in 2009. Given our concerns over valuation we are inclined to reduce our exposure here and move to a value driven approach over growth.
The Febraury correction barely registers on this chart, using a log scale, and has bounced off the 200 day moving average, which we have been suggesting as a minimum retracement for some time. So far so good, but we still find US markets egregiously expensive.
The Italian elections are on Sunday, 4 March, and as we write the outcome is unknown, but the leader of a party expected to be part of Italy’s ruling coalition has insisted the country’s future lies with Eastern European nations rather than the “French-German axis that commands Brussels.” Mrs Meloni’s Brothers of Italy party (FDI), forms part of a centre-right coalition widely tipped to have the best chance of forming a government. Extraordinarily, the alliance is steered by former Prime Minister Silvio Berlusconi who, though prevented by Italian law from taking his country’s top job once again, has certainly made more comebacks that the Comeback Kid! This would not sit well with the Brussels/Berlin axis, who, in a fit of pique for which they are renowned, may well make Theresa May’s job harder than it is already, pour encourager les autres. There are still some pockets of value in European markets, however, and any electoral fall out would be an opportunity.
We have seen the pull back, to the 200 day moving average, that we were anticipating. We suspect that local rather than global companies are going to benefit most from the reforms that Prime Minister Abe has in mind. The very strongly held consensus view is that the US dollar will regain its strength which of course helps Japanese exporters; not something with which Mr Trump will likely put up with for very long. If Japan is to regain its former status the Yen may well be the currency to own, along with domestic companies.
Asia Pacific and Emerging Markets
A correction of sorts but not yet back to the 200 day MAV. Both market sectors are heavily influenced by the moves in the US dollar index, and, as we have already alluded to, the consensus is that the US dollar will strengthen. In the short term this may be the case, which will provide an opportunity to add exposure on a market pull back. Long term the demographics of this region are the big positive. The Emerging Markets’ chart shows a very similar pattern still being significanlty overbought in short term.
Commodities and Gold
Gold had a strong year in 2017, also helped by the relative weakness of the dollar. If the consensus view on the greenback fails to materialise then it could be a very good 2018 too; particularly for mining stocks, which still languish at lows relative to the gold price – the green line on the chart.
Like some equity markets the oil price is becoming very over-extended to the upside but could reach resistance at $70 before a more meaningful correction. The implications for the global economy in the short term are highly inflationary and this is coming through in rising transportation costs, which feel the immediate impact of higher pump prices.
Commodities in general have been out of favour for some time as the chart of the GS Commodity index relative to the S&P 500 clearly shows. A rising line indicates commodities outperforming the S&P and vice-versa. Given our views on the US equity markets and the bullish potential for gold and oil, this trend could be about to change. Commodity plays are good providers of portfolio diversification.
Without doubt the proverbial canary in the coal mine is the bond market. Some of us, getting on for 40 years, have been watching its relentless rise beginning with yields peaking at 16% in the early 80s. With the Fed in tightening mode and three more rate rises to come in 2018 being highly probable, on top of more Treasury issuance to fund the Trump tax bill, it is little wonder that 10-year yields are on their way up. The perceived wisdom is that if rates reach 3%, a number to which we are very close, buyers will return to shore up the market. Let us hope this, in fact, turns out to be the case. With so many derivative positions currently “betting” that 3% is the limit, any surge through such a ceiling would very quickly turn into a rout.
Bonds of most flavours are off the menu, apart from index-linkers, floating rate notes, and some of the very best credit funds with asset backing. There are also some good absolute return bond funds that are worth considering, as proxies for the “run of the mill” corporate bond and sovereign debt funds, where liquidity in a sell off is also becoming an issue.
In the short-term any equity market weakness could well induce some risk-off buying of bonds, and should the Fed’s rate rises tip the US into recession, then they have hinted at negative interest rates, which would keep the bond bull market going for a while. However, buying paper with a built in negative real return is the current definition of insanity.
Central bank rhetoric has changed, and options for withdrawing QE are on the table while rate rises in the States are rising apace. As usual central bankers caveat their prognostications, and are likely to return with further accommodation if asset markets show any serious weakness. We doubt that such an outcome would be as well received as the central banks anticipate…
- Government bonds are heroically expensive – the trend in rates appears to be on the turn.
- Spreads on corporate bonds are still tight and several European issues are trading on negative redemption yields. On that basis, they are ridiculously expensive and default risk can only rise from here, also making high yield potentially less attractive. Is the yield premium adequate? It would appear not, given the increasing level of selling seen in this sector. There is also significant concern over liquidity risk, despite central bank buying (Europe and Japan) and regulatory stress testing.
- Western equity markets are long overdue a correction; have we had it? The jury is still out.
- Property is attractive, as a real asset offering a higher spread against most fixed interest markets, but with the gating of many UK bricks and mortar funds in 2016, due to large redemptions, their attractiveness is now questionable. REITs are equities in disguise.
- Elections are coming back to haunt European markets. With the prospect of more to come in Italy, in March, a degree of caution of caution might be required. Conventional wisdom says that ECB QE should be beneficial for financial assets, but the Greek issue and the recapitalisation of European banks are yet to be fully resolved, plus, Draghi has threatened to start removing the QE punch bowl. It is unlikely, however, that the ECB would allow things to get out of hand: but how well will any response be executed? The Nikkei index has pulled back to the 21,000 region and looks poised to move higher; domestic issues are preferred. Emerging and Asia Pacific markets are not overly expensive as a long-term position, but will continue to be volatile and affected by dollar machinations and Chinese economic weakness.
- Demand for the physical metal continues to be strong, and sentiment is returning with new gold markets having opened in Shanghai and Dubai, mindful of the world contemplating the latest North Korean threat. Mining shares are not unattractive.
- Commodities have potentially reached a bottom relative to equity markets.
- The central banks have a significant unknown variable to contend with; the US President. Sovereign bond yields are rising on expectations of higher interest rates; not for the first time in recent history. Global economies are still fragile and any shock to the system is likely to be met with further central bank “largesse”. We observe closely for signs of success… or failure.
Clive Hale – 1 March 2018
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