Last month can be characterized by more of the same. In short: global economic growth continues to stall; financial conditions remain loose and (geo) political risks are largely unchanged. All eyes remain focused on Brexit and US-China trade talks. Short-term volatility picked up somewhat but is still considered to be in a low-to-medium regime.
Risk assets saw rising valuations in March with the S&P 500 posting its best quarter since 2009 but momentum is slowing. The first signs of market turbulence occurred on Friday the 22nd of March with equity markets logging their worst day in recent months and implied volatility jumping ± 21%. The move appears driven by further disappointing economic data and an inversion of the yield curve as the spread between the 3-month Treasury Yield and 10-year Note Rate turned negative for the first time since 2007. It has since turned positive again. Historically, a yield curve inversion has been a useful (but not flawless) predictor of recessions. But this was before the ‘new normal’ of Quantitative Easing, so use at your own risk.
Is there still some breath left in this late phase of the business cycle? In our opinion there is but the path is narrowing and we remain convinced that risk is to the down-side.
February has been almost eerily silent with little to no volatility driving events. In aggregate, news flow was marginally positive and has resulted in small but steady gains for risk assets. Short-term volatility was down across asset classes and can be considered low for historic standards. Headwinds from a stalling global growth outlook and disappointing growth in Europe appears to have been offset by more accommodative rhetoric from central banks (i.e. QT on pause), a positive economic growth surprise in the US and hopes of an imminent US-China trade deal. So while signals have clearly been mixed, the annualized performance of risk assets has been extraordinary and volatility has all but disappeared. A sign that smooth sailing lies ahead or that of growing complacency? We think it is the latter and that tail-risk is asymmetric to the down-side in the short to medium term.
January has offered investors some respite as markets rallied and risk assets made up most of their losses in an almost V-shaped recovery. The Fed dovish rhetoric on both the future path of interest rates and the balance sheet reduction plan has quelled any fears of tighter monetary policy. This takes away a key headwind (for now), but the risk remains to the downside with global economic growth stalling and little relief on political uncertainty such as US-China Trade talks and Brexit. What was somewhat unusual is that bond markets rallied too. So, the market outlook appears to be mixed and nearing an inflection point. Where are we in the business cycle? Are we still in a late-cycle phase or are we entering an end-cycle phase? With QT on hold, the current expansion could be stretched and risk assets could continue to outperform, as they have done historically in late-stage cycles. In our view, something has got to give and we should prepare for a bumpy ride.
Just a Glitch?
The occasional earthquakes anticipated in our November newsletter came without much delay and hesitation. Global markets showed sharp declines with many markets down double digits. The US equity markets booked their worst year since the financial crisis and the worst December since the Great Depression. To illustrate, the S&P 500 index fell 9.2% during the month. It is not a surprise then that volatility, both realized and implied, spiked.
Investors looking for a silver lining might want to focus on the highly anticipated ‘Powell put’ that has gotten more traction. After hiking rates in mid-December, The Fed Chairman recently said that he was ‘listening very carefully’ to financial markets and would balance the steady flow of strong economic data against the potential of an array of risks. So far markets are not pricing in the anticipated two rate hikes in 2019 and markets even consider the Fed more like to cut rates instead. In our view, the recent change in risk appetite is there to stay and pausing the tightening of monetary policy is not likely to quell the current worries about global economic growth.
To reference president Donald Trump: just a ‘Glitch’? Unlikely.
Another month of rising bond yields continued to put pressure on equity valuations. Three month US treasury bills (as about as risk free an asset as you can find) yielded more than core inflation in the US for the first time since 2007. In the intervening period investors in cash have been penalised 1.5-2% annually by inflation. Now, once again, investing in (USD) cash generates a positive real return.
This continues our theme of QE switching to QT; QE’s purpose was to force money out of risk-free assets (by reducing their yields and so making them less attractive) and into more risky assets. QT, definitionally, should do the opposite. As QT progresses, we should see the riskiest assets (high growth, but loss-making companies) sell off the most. There should be a movement of money from high growth equities to value equities (a reversal of a years-long trend) and finally into risk-free assets. We saw the beginnings of this process during October, but the tectonic plates of QT are likely to continue to drift, with occasional earthquakes.
“If QE forced money out of risk-free assets into more risky assets, QT, definitionally, should do the opposite. With the US leading the cycle transition from QE to QT, risk-free assets are looking more and more attractive. Focusing on the 2 year bond as a measure of “risk-free” return, 3% is starting to look enticing. As QT progresses, we should see the riskiest assets become increasingly less attractive with a growing risk of a deep correction."
“The spread between US and German 2 year bond yields is at a post-1989 high. Since the late 1990’, whenever the spread has reached more than 2%, equity markets have subsequently sold off, and whenever it has gone negative, equity markets have subsequently rallied. With the spread now over 3.4%, we’re 2 years late for a sell-off, by this measure. Food for thought at least.”
Is the US equity market overheating?
Subdued volatility points to a certain complacency, however the current term structure of implied volatility indicates that the tail risk has considerably increased over the last few weeks and remains close to historical highs.
To add to the two mini-crises this year: the inverse VIX meltdown in February, and more recently the Italian potential-euro-exit in May, we can now add a bear market in Chinese equities. The last is easily ascribed to Donald Trump’s talk of a trade war, but probably too easily; it more likely has its roots in a cooling Chinese consumer. As we said last month, real negative news is actually negatively impacting asset prices (as it should, but didn’t, in 2017); we still see this as positive. What concerns us slightly more is that these incidents tend to be contained to small pockets of assets (VIX to equities, Italy to Italian bonds). What we haven’t seen since late 2015, is a broad-based sell-off, predicated e.g. on falling growth expectations (a la 2015/16), or simply just valuation (1999/2000).
We are also wary of the potential for a big carry trade emerging in euro/dollar, as economic growth and interest rate policies continue to diverge. At 2 year maturities, the spread between the two has progressively widened up to 3.2% now. Unhedged carry trades must be starting to look tempting, particularly as the dollar has rallied against the euro for most of this year. This process in itself can further strengthen the dollar. But ultimately when the trade gets too crowded and/or the yield differential narrows it can all reverse. One to watch.
Our Joint Venture Rsquare (combining Arkus and BeeAM) just received the certification from Finance innovation.
We’ve now seen two mini-crises this year: the inverse VIX meltdown in February, and more recently the Italian potential-euro-exit last month. We make two observations: first, in both cases real negative news actually negatively impacted asset prices, as it should, but didn’t in 2017. We take this as positive. Second, the impact was remarkably contained: in the first case almost entirely to equities, and in the second to Italian bonds and equities, and to a lesser extent the euro. What we haven’t seen this year, in fact haven’t seen since late 2015, is a broad-based sell-off, despite several potential causes (trade war, North Korea). We are a little more concerned by this: markets seem slightly too complacent to us.
As eurozone PMI’s and GDP estimates have eased recently, we could also expect a slower exit from QE by the ECB, which should remain supportive of asset prices. The US economy remains strong though, so we might expect to see increasing divergence in inflation and bond yields, and possibly an even stronger dollar. But overall we see less reason to expect higher volatility in the next month or so.
Evolution, not revolution
Evolution, not revolution.
Disruption» is probably one the most used buzz words over the past few
years. Disruption of business models, disruption of traditional market segments, and disruption in finance is a common subject of many articles and conferences. In that respect, disruption is often associated to radical innovation. But is it really the case? Is radical innovation the only way to innovate? And what is the aim of innovation, disrupting or brings progress? And for entrepreneurs and even well-established companies, how to handle this fast-moving environment and take advantage of it?
Leading Edge Conference in London
Starting 3rd of October, Arkus will be one of the main sponsors at the next Leading Edge Conference in London!
Martin Ewen, Chief Operating Officer, will be one of the speakers and would be delighted to meet you on-site.
Quantitative Finance Symposium
Arkus is proud to sponsor the first Quantitative Finance Symposium “QuattroPole++” at Trier University, October 13th, 2015.
Séminaire Private Equity
Mercredi 28 Octobre 2015 - Luxembourg (Plus d'information à venir)
2 ans après la transposition de la directive AIFM, quel est le bilan ? Quelles sont les best practices ?
Quelles opportunités pour la distribution transfrontalière de fonds alternatifs ? - Résumé et photos de l'événement
Petit-déjeuner de travail
Jeudi 18 Juin 2015 de 8h30 à 10h30
Swissotel Métropole Genève
IFBL Risk training
Thursday 04/06/2015 - IFBL
Axelle Ferey, General Manager at Arkus Financial Services facilitated an IFBL training on the following subject: "Understanding Business Processes and Controls in Private Equity"
European Risk Management Conference - Highlights and photos
Chamber of Commerce, Kirchberg, Luxembourg
Did you miss the ALFI/ALRiM European Risk Management Conference? Check out the highlights and photos here.
Operational Real Estate, PERE & Debt Fund Management Conference
Parc Plaza - Central Luxembourg
The 11th Annual Real Estate Fund Servicing Conference - Operational Real Estate, PERE & Debt Fund Management
Risk Assessing, Monitoring & Reporting under AIFMD to Regulators & Investors
Formation - Reporting sous AIFM
Private Equity - Comment le Luxembourg renforce-t-il son positionnement sur ce marché concurrentiel ?
DoubleTree by Hilton, Luxembourg
Conference - AIFMD one year after
September 18th & 19th 2014
Hilton – St. Julian’s Bay – Malta