So far in 2018, markets have grappled with rising bond yields, full employment, US Federal Reserve tightening, a weak USD currency and rising fiscal deficits, spurred by tax reform. We have seen these exact issues before. The year was 1987.
The dramatic market events over the last week are a stark reminder that markets don’t always reflect economic reality. The global economy continues to improve in a late business cycle environment, but below the surface, the markets have grave concerns about the withdrawal of Central Bank liquidity and ultra-low funding rates. Now that the volatility genie has been released across global markets, it is unlikely the calm of 2017 will return.
Volatility breeding more volatility
We are not forecasting a near-term market calamity, however, it looks increasingly possible as market volatility feeds on itself and drives price action. After such a positive run for risk markets in the low volatility environment, a dangerous complacency lurks.
Until this week, the S&P 500 had gone around 406 days without a 5% correction. The issue for long-only investors remains that now quantitative and computer-driven algorithms (who do the vast majority of trading these days) must now load significantly higher volatility readings into their models. With a higher volatility input, the model must rebalance and this means selling assets into the market. As these systems sell (often as a collective herd), new sponsorship needs to be found for those assets that are being disposed (clearly new buyers have different valuation methodologies, ie their valuations ideal is lower otherwise they would already own those assets).
This deleveraging effect will in itself feed into greater volatility as spreads widen and ranges increase, again lifting the volatility input for quantitative systems, hence triggering another round of liquidations and de-risking. The increase in volatility is extremely common at market tops and a warning bell is in play after the parabolic type moves at the end of the market cycle. This seems to fit the bill for January as we saw equity funds globally enjoying their largest monthly inflows on record, attracting approximately $100 billion in January.
RBA takes rate move off the table
High-grade bonds backed by Governments can help investors increase the defensiveness of portfolios and reduce volatility. Since Brexit in June 2016, bond valuations have improved considerably and now sit at the highest yields seen versus the RBA cash rate in some time. We have long argued that the RBA will not move interest rates in 2018, a theme solidified by explicit remarks from RBA Governor Lowe last night, who stated that a significant rise in inflation combined with a closing of the employment gap would be required to consider a move.
Both such moves would take considerable time to manifest, essentially taking any RBA move off the table for 2018, making Australian high-grade bonds a highly credible defensive option for portfolios after their recent cheapening. Moreover, a high AUD currency combined with further ‘out of cycle’ mortgage rates hikes further challenges any possible moves. Australian consumers are the second most indebted in the world, suffering under record low wages growth whilst utility prices and high debt burdens constrain consumption, which makes up 60% of the economy.
Equity market corrections can pull back the curtain on other investments and whilst the recent market meltdown was driven by volatility-linked investments, we are closely monitoring other investment structures such as exchange-traded loan funds and credit, where investors have loaded up in the belief that floating rate debt will shield them from losses when interest rates rise. In times of market stress, such instruments have positive correlations to equities, so instead of helping portfolios weather the storm they can act as a hindrance.
There is never one cockroach
A liquidity event in this credit space would have drastic effects – given the recent snowballing of the loan market – issuance rose 50% last year to $1.5 trillion. Credit markets are an important conduit to help companies fund their growth. The recent confession by Netflix that they will chew through $4 billion in cash next year reinforces the need for financing and how liquidity and credit premiums are not to be treated with complacency.
A defensive allocation to a balanced portfolio must be of unquestionable asset quality and provide liquidity. With credit spreads at, or below, levels seen pre-GFC, credit is unlikely to provide that bedrock. Now more than ever may be the time to rethink defensive portfolio allocations.
Charlie has spent over 15 years in the financial services industry working for Merrill Lynch and Bank of America Merrill Lynch (BAML) as a Bond trader; trading in Tokyo, New York, London and Sydney.
"The increase in volatility is extremely common at market tops and a warning bell is in play after the parabolic type moves at the end of the market cycle." The academic evidence tends to disagree. In their April 2017 paper entitled “Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 Historical Bubbles”, Didier Sornette, Peter Cauwels and Georgi Smilyanov examine price volatility before, during, and after financial asset bubbles in order to uncover possible commonalities and check empirically whether volatility might be used as an indicator or an early warning signal of an unsustainable price increase and the associated crash. Somewhat contrary to previous academic and practitioner claims, the main finding of this paper is that there is no systematic evidence of increasing volatility as a diagnostic or an early warning signal that a bubble is present and or developing. Sometimes volatility does tend to increase, other times it decreases before a fall, and most of the time volatility barely changes as the bubble develops towards its end.