Domestic Markets – 1Q18 Review
Volatility is back. Is it a new paradigm or return to trend?
The relatively unabated rally in U.S. equities that has been in place for the past two years hit a shallow divot in the first quarter, with the S&P 500 Index posting a return of -0.8% for the first three months of 2018. Stocks started the year on a strong note, with the S&P 500 gaining almost 6% in January – a record-tying 15th consecutive month of positive returns for this index. Equities then corrected by ~10% in February before recovering, only to repeat a similar sequence (though not to the same magnitude) in March. After a placid 2017 in which the S&P 500 registered just eight trading sessions of a 1% move (up or down) for the year, the market has already posted 23 such instances thus far in 2018.
Volatility – A New Paradigm or Return to Trend?
In considering the investment climate of 2018, a look back on market conditions in 2017 is helpful. Last year was in many ways a near-perfect environment for equity investors: a synchronized global economic expansion, continued low-interest rates, favorable corporate earnings, and generally positive economic and political developments. Entering 2018, change within the market was bound to occur – and as these somewhat inevitable shifts have emerged, so too has volatility. We believe the following considerations will play a role in market behavior during 2018 (and beyond).
- Positive real interest rate. Monetary policy has been the primary tool to promote the global recovery over the past ten years. With U.S. inflation levels running at close to 2% and with the economy having achieved full employment, the Federal Reserve is now raising rates back to a positive real number. Assuming at least two more rate hikes in 2018, the resulting Fed Funds rate in the 2.25% range would be a positive real rate of return for the first time this decade. As the debt and equity markets have become quite comfortable with an extremely low economic cost of capital, the withdrawal of monetary stimulus is bound to exert pressure on asset prices. While many have anticipated this eventuality, it would be naïve to believe that this process after such a long duration will be a smooth one. We believe the rise in interest rates as an explanatory variable for the rise in volatility exceeds most other factors.
- Quantitative Easing (QE) programs outside the U.S. are reaching their limits. QE remains to this day a difficult concept to explain. While it looks like money printing, it is in fact the simultaneous creation of bank reserves and the removal of risk-free instruments from the financial system. The objective is to urge financial participants out on the risk spectrum. In this regard, the QE programs of both Japan and Europe have gone further than the U.S. Federal Reserve. In Japan, the vast preponderance of positive-yielding debt has been bought by the Bank of Japan (BOJ); the BOJ has subsequently expanded their purchase activity into the corporate debt equity (via ETF) markets. In Europe, the European Central Bank (ECB) is bumping up against ownership limits for sovereign issues. The result in both cases is a shortage of risk- free bonds of various durations, an essential source of collateral for interbank liquidity. The resulting reduction in liquidity makes longer-term currency hedging prohibitively expensive for market participants such as major Japanese and European manufacturers – and thus blunts the benefit of QE. We believe Europe’s improved economic performance means that the ECB will begin exiting QE in 2018, and raising interest rates back into positive territory in 2019. Japan’s situation is uniquely complicated and we don’t expect QE to end there in 2018; however, given that the QE program is leading to illiquidity and challenges in basic capital market functions, returns appear to be diminishing.
- Tariffs and Trade wars? – President Trump has shown a clear willingness to approach negotiations through a confrontational style, including the topic of global trade. Tariffs on steel and aluminum, and possibly on select Chinese manufactures, likely represent negotiating tactics to force some kind of “deal” or reconciliation. Even so, for this to be an effective tactic, there would need to be some willingness to implement stiff tariffs in certain categories, just to prove that these are serious threats. As such, there is some risk that these tariffs “reverse” key stimulative benefits of tax reform and the general economic momentum. Global trade linkages have become deeply integrated – broadly speaking, it would take a lot of regressive tariffs to rupture these relationships. At the margin, protectionist policy is not a favorable development. That said, Chinese IP theft, forced technology transfer, and domestic market protections are difficult to defend as reciprocally reasonable trade policies to tolerate in the long term. Outside the U.S., the EU has proposed a transaction tax on internet businesses, reasoning that these are disruptive to local economies and tend to channel revenue and profits into the cloud and the most favorable tax jurisdictions. With locally sourced “profits” difficult to quantify, the EU may tax revenue. Taken in isolation, these may be reasonable responses to the negative externalities posed by online businesses. As it happens, these are mostly U.S. companies, and the largest ones in the global stock market, and they may earn less money than would otherwise have been the case.
- Market Structure – Global equity market ownership is vastly different from the pre-GFC timeframe. Index funds, sector ETFs, and quantitative strategies have come to predominant markets, in some cases owning an outright majority of certain stocks and their free floats. On the other side of the markets, active managers have vastly less firepower to deploy as prices move. The consequence is that small fluctuations in market flows can lead to outsized stock price moves. Not unlike the unintended consequences of QE detailed earlier, true stock market and individual stock price liquidity (i.e., the amount of money needed to move a stock price) is lower today than in the past.
What are the investment implications from a rise in volatility? While low volatility can often suppress stock dislocations and related pricing inefficiencies, larger return differences within and across sectors that often accompany higher volatility markets should result in more opportunities for active stock pickers such as Cambiar.
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