Global assets sideswiped as bond markets re-awaken to risk
After logging the strongest January in 20 years, with an overall monthly return of almost 6% for the S&P 500 Index, the last week has seen sharp reversals in some overvalued asset markets and a rush out of crowded positioning by investors.
As February began, the S&P Index had risen consistently for 15 months in a row, achieving a post-1928 record of 404 successive trading days without a 3% decline from a prior Index high. Measured market volatility has remained so low for so long, that the trading strategy of selling derivatives-based insurance against sudden market moves has become an extremely popular means of supplementing returns in a low-yield world. Exchange-Traded Funds (ETFs) have proliferated in recent years and a subset of these vehicles are structured to cut portfolio losses in adverse conditions by relying on computer-driven trading algorithms to enter and exit large positions very quickly, amplifying market moves over short time-frames.
As the Friday trading day advanced, substantial long positions in equities were rapidly trimmed, leading to an overall loss for the week of just under 4.0%. The main US options exchange saw a record 4.3 million contracts traded on Friday – 39% above the previous record set on 1 December. The overall picture was one of a scramble to re-position by investors who had become excessively reliant on the continuation of last year’s main market trends. However, one recent phenomenon – that of the market underpricing the Federal Reserve’s own stated interest rate normalization track – is clearly now unlikely to continue, as the consensus shifts toward accepting higher inflation risk.
Comments from Federal Governor Kaplan that “more than three rate increases may be needed this year” added fuel to the fire, reinforcing the value of the old axiom: “Don’t fight the Fed”.
Good news was bad news, last week
Unusually, the immediate catalyst for the sudden change in mood from near-euphoria as January ended to skittishness and a rush to take profits on Friday was not an external shock but a convergence of positive US economic news.
For Janet Yellen, Friday’s 2.5% drop in the Dow Jones Industrial Average, accompanied by an intensification in this year’s Treasury bond sell-off, must have made for an unpleasant last day on the job as Federal Reserve Chair. And yet, the economic news last week was largely benign. Friday’s payrolls report signalled above-expectations jobs growth in the US in January, a steady unemployment rate of 4.1%, and a long-awaited upturn in average hourly earnings. Corporate earnings upgrades by analysts have also been unusually positive in recent weeks and another year of double-digit earnings growth is likely for US companies. Robust demand, tax cuts and pro-business regulatory reform are highly supportive factors and the lower USD in recent months will aid profits for US multinationals.
President Trump’s first State of the Union address, taken along with his more mature World Economic Forum appearance, have instilled the impression that Trump’s policies are pragmatic mercantilism at their core, and serious trade-war confrontationalism will likely be more of a bluffing strategy for the Administration than a central policy goal. Having achieved tax cuts, Trump re-iterated the wish to prioritize infrastructure in 2018 and a willingness to use both public and private borrowing to make the upgrades possible.
These developments, which could equally be read as promising a strongly consolidating growth story, were interpreted late last week to mean a notably more hawkish Federal Reserve in the years ahead, with less tolerance of potentially inflationary pressures and a more aggressive interest rate tightening programme than markets have expected. That remains to be seen, but the leadership transition from the outgoing Democratic Fed Chair Yellen to the incoming Republican Jerome Powell today is clearly now being flagged as a risk factor in an environment of Federal budget stress, an upcoming debt ceiling expiry and a bitterly divided Congress.
Can the S&P 500 reach 3,000 if bond yields hit 3%?
Source: Financial Times
Shades of 1994? History doesn’t repeat, but it rhymes
Market historians will remember the “Great Bond Massacre” of that year, when an adviser to President Clinton remarked that he “wants to be re-incarnated as the bond market, so he can intimidate everybody”. 1994 began with historically-low Treasury yields, an embedded economic expansion from the deep 1991 recession, price stability, and low wage growth. However, a resolute Federal Reserve which began raising the policy interest rate in response to economic strength and rising commodity prices, triggered a bond market panic which also overshadowed equity markets for much of the following year.
Are there risks of a repeat performance twenty-four years later? Two years ago, the respected Deutsche Bank economist Torsten Slok warned that continued unwillingness of bond investors to accept the eventuality that the Federal Reserve will pick up the pace of tightening could indeed lead to a “1994 redux”. On the other hand, much of the anxiety in 2018 so far is focussed on higher inflation pressure, not on higher actual inflation outcomes.
We believe that, although the current Federal Reserve Board is likely to prove vigilant on inflation and (fairly) resolute on gently unwinding quantitative easing, it remains prepared to pause for extended periods in the event that inflation fails to accelerate as their models predict. Thus, with the US 10-year bond yield having doubled from 1.4% in July 2016, and now having risen 0.50% in just over two months, en route to arriving at a reasonable “fair value” estimate between 2.80% to 3.00%, the brunt of this correction may already be past. Nevertheless, overshoot to the higher side on yields remains a short-term risk.
Asset strategy implications
We have long highlighted the chief risk to investment market medium-term returns would be a phase of sustained, simultaneous weakness in both bond and equity markets. Our portfolios have remained somewhat defensively positioned with this risk scenario in mind.
We retain a neutral overall weighting to equities (both global and Australasian) because, despite an improving world economy, the risk of disruption from a yield shock has become ever more worrying. We also have a low allocation to fixed income securities, with underweights compared to our benchmarks for both International and New Zealand bonds. We have for similar reasons preserved a small bias against the New Zealand dollar and in favour of foreign currencies, because the kiwi currency tends to suffer in periods of risk aversion and the yield advantage of investing in New Zealand debt instruments is shrinking as global yields track upwards.
Because the current ructions in markets come after a very strong run-up (one commentator called the December-January US equity rally “parabolic”), they probably represent a healthy consolidation rather than an enduring market peak. The increased earnings prospects of global companies has actually reduced their degree of over-valuation recently. However, as highlighted in our recently-released Quarterly Strategic Outlook
, we do expect 2018 to be a rougher ride in markets than 2016-2017 as some overdue adjustments in pricing and position crowding play out across the globe.
We focus on the underlying economic and profitability strengths supporting our equity holdings, on the superior credit quality distinguishing our fixed interest portfolios, and on the fact that we are not fully invested – we have a higher-than-normal allocation to cash, as we see little real undervaluation around the world to take advantage of at present. While this ‘dry powder’ approach of retaining a decent cash weighting may restrain our overall gains somewhat during ‘raging bull’ phases, it also positions our funds better to minimize capital losses on both bonds and equities accruing together during moments of inflation anxiety.
This cautiously optimistic strategic bias will be retained and can be adjusted easily to either a greater degree of defensiveness or to the acquisition of better-valued securities in the event of a deeper correction than the current re-pricing.
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