“Slower growth, higher wage costs, rising interest rates, a negative liquidity trend, record-high margin expectations and stretched valuations leaves little to no room for negative surprises. We see further downside for equities the coming 6-9 months.”
Higher US interest rates spurred by new signals from the Federal Reserve have triggered a sell-off in equity markets over the past two weeks.
Most of our global macro and market predictions for 2018 have proven correct, even though it has been a rocky road until the recent market sell-off. We once again reiterate our negative stance on risky assets, which we first formulated in mid-May. The forward-looking business cycle has passed its peak and leading indicators suggest to us that the lost momentum should continue well into 2019. A weaker trend in real economic indicators is therefore imminent, some of which have already started to contract.
The rise in underlying inflation pressure, stemming from tight labour markets, is showing no signs of easing. We believe quite the contrary – and therefore that monetary policy risks being behind the curve. Rising real rates are another factor we need to add to our cocktail of a failing business cycle with too-lofty profit expectations. Even after the recent sell-off, we believe that the stock market still expects much too rosy a future – disappointments lie ahead.
We have been surprised by the very strong US stock market and that the global growth slowdown has not leaked back to US growth numbers. Until last week, it has been costly to underestimate Trump and his pro-cyclical fiscal policy, not to mention the effects of the huge equity buyback programmes (a double-edged sword that has prolonged the bull market, but historically has also been a late-cyclical sign of a stock market top in the making). Over the last 20 years there has basically never been such a long period with the US stock market powering ahead so strongly at the same time as the rest of the world is trending down, the way it has since late January 2018. It cannot continue forever. Something has to give. We still expect that the force of business cycle gravity will now turn to the US economy and US assets. Maybe we have just seen the start of that.
The reason for this is that it has historically taken about 1.5 years for monetary policy tightening to really weigh on the leading indicators of the US economy, which would roughly correspond to now. There are already a number of such gauges that have come down, without the stock market taking notice.
Risk on the rise
The recent rise of market risk comes as no surprise to us. Instead, it had been the absence thereof that we found puzzling. Our multifactor analysis indicated that at least a normalisation of market volatility should be expected. We pinpointed two possible triggers, of which at least one – seasonality – has now incited a rise in market volatility. The second trigger – softer momentum in the business cycle – indicates that the rise in market risk should persist for some time ahead. Therefore, we argue that strategies that improve a portfolio’s risk/reward should be implemented. We identify three factors to overweight and one additional overlay.
Absence of volatility was the surprise, not its reoccurrence
Given the trade disputes, debt issues, a looming Brexit and a forward-looking business cycle that is rolling over, the absence of market volatility until very recently was a true conundrum. As we pinpointed back in September, a multifactor analysis suggested that market volatility was set to rise. A flattening US yield curve normally heightens equity and FX market volatility. A rise in fiscal deficits and lower USD reserve liquidity imply a rise in bond and FX volatility, respectively. When adding the sharp rise in perceived global policy uncertainty, the low market volatility was, and to some extent still is, a conundrum.
In recent weeks, equity and bond volatility started to reverse. VIX traded at around 12 a month ago and is now at 23, a six-month high. Hence, mean reversion has occurred, and the index is even trading somewhat above the long-term average of just below 20.
So far, the jump in the VIX falls short of the spike from February, a risk scenario we highlighted as the market was as short in the VIX positioning in September as it was at the end of 2017. Although the fundamentals are in place, we argue that a trigger is probably needed for market volatility to rise across major asset classes. The reason for the higher volatility seen over the past couple of weeks is possibly a seasonal factor in October and November. For lasting normalisation of market risk (ie higher volatility), the perceived stability of underlying growth needs to be challenged.
…the retraction of the US manufacturing sector momentum should qualify as such a trigger. If this were to evolve into a sudden and sharp rise in market volatility, the appetite for risk would be lost. Risky assets would suffer the most, with credit spreads and equity prices taking the biggest hit. Buying out-of-the-money puts would certainly be the most straightforward strategy to protect asset value in a portfolio. However, our analysis also shows that stocks characterised as being of high quality, low volatility and inexpensive (especially relative to the rest of the market) normally outperform the rest of the market.