Why So Volatile?
Financial volatility is back. Four reasons why.
Financial market volatility was by several measures the lowest in history in 2017, with a maximum drawdown of just 3% and an extremely low frequency of >1% stock market days. The conditions that brought this about appear to be ebbing, and this is resulting in greater market uncertainty and liquidity-dislocation. In 2017, key financial market variables were uniquely positive. These included: 1) synchronized global economic expansion and acceleration, 2) continued low interest rates (with real short-term interest rates <0% throughout the developed world), 3) very favorable earnings developments and success to growth and momentum stocks (these dominate indexes), and 4) generally positive economic and political developments. By the later part of 2017, the absence of volatility in particular led leveraged financial strategies to extend portfolio leverage and reduce shorts to a minimum (“shorts off”), while in fixed income, the thirst for yield led corporate bond spreads to trade down to exceptionally low levels.
In short, for varied reasons the environment was about as close to perfect as one could have hoped for. As markets entered 2018, change was bound to occur, and as these somewhat inevitable shifts have emerged, so too has volatility. Shorts are back on, and leverage models dictate lower exposure in a more volatile market. We believe the following are each important to understand and take some account of in 2018+
A Positive Real Interest Rate Arrives
Monetary policy has been the primary tool to promote global recovery from the GFC, Great Recession, European financial crisis, and Japanese deflationary lost decades. With U.S. inflation running at close to 2% and with the U.S. economy having achieved full employment, the Fed is now raising rates back to a positive real number. Assuming at least two more rate hikes in 2018, Fed Funds should exceed 2.25% which would mean a positive real rate. That… has not happened in over 9 years! The Fed is also intent on shrinking its balance sheet, which may also tighten liquidity in key categories. Financial markets for both debt and equity 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 as the performance of the U.S. economy has been very strong, it would be naïve to believe the withdrawal of monetary stimulus after such a long duration will be a smooth process. We believe this as an explanatory variable likely exceeds most others.
Recent spread widening in corporate bonds, the LIBOR-OIS rate, and reduced volumes/liquidity in categories such as commercial real estate may have their own fundamental drivers, but the arrival of these alongside a positive real interest rate and Fed balance sheet shrinkage do not seem coincidental.
QE Programs Outside the U.S. are Reaching Their Limits.
Quantitative Easing (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. This creates capital for banks and urges financial participants out on the risk spectrum. In this regard, the QE programs of both Europe and Japan have gone further than the U.S. Federal Reserve. In Japan, the vast preponderance of positive yielding debt has been bought up by the Bank of Japan, which has moved into corporate debt buying and even equity ETF buying. The ECB is bumping up against ownership limits for sovereign issues. In both cases, this leads to shortages of risk-free bonds at various durations, an essential source of collateral for interbank liquidity. While this is a technical issue, it reduces liquidity, making longer-term currency hedging prohibitively expensive, for example, for major Japanese and European manufacturers. This blunts the benefit of QE. Europe’s improved economic performance means that Europe and the ECB are close to being in a position to exit QE in 2018 and begin 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 it is leading to illiquidity and challenges in basic capital market functions, returns appear to be diminishing.
Tariffs and Trade Wars?
Donald Trump has shown a clear willingness to approach negotiation 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 that is out there. Global trade linkages have become deeply integrated – it would take a lot of regressive tariffs to rupture these broadly speaking. At the margin, these are not favorable developments. That said, the most recent target of tariffs, 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.
Global equity market ownership is vastly different than pre-GFC. Index funds, sector ETFs, and quantitative strategies have come to predominate 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 (ie the amount of money needed to move a stock price) is lower today than in the past.
We are beginning to bear witness to now that the rather perfect set of financial variables that prevailed in 2017 is giving way to something else. Accordingly, the volatility episodes of Q1 2018 are apt to continue during the year.
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