The good, the bad and the ugly … why the calm in stock markets is over
So concerned have markets become about an inflation-induced tightening in monetary policy that stronger growth is now perceived as a threat. This is preposterous
Volatility in financial markets is back with a vengeance.
On Monday, US equities suffered their sharpest decline since August 2011, helping wipe off a staggering US$1.4 trillion from the value of the world’s stock markets. A mere 24 hours later, the benchmark S&P 500 index staged a dramatic rebound, enjoying its best percentage gain since Donald Trump was elected US president and triggering a recovery in global stock markets.
Given the fierceness of the rally in equities – even after the recent convulsions the S&P 500 has not suffered a daily decline of more than 5 per cent for over 400 days, the longest streak since the 1950s, according to Bloomberg – and the historically low levels of volatility over the past year, it is not surprising that the turmoil is being treated by many analysts as a turning point for markets.
While it remains to be seen whether Monday’s bloodbath was a foretaste of things to come, the erratic moves in markets over the past fortnight are encouraging and deeply worrying in equal measure.
The Good: The recent fall in government bond prices, which played a part in the equity sell-off, was long overdue and is a healthy development. A 10-year US Treasury yield of 2.4 per cent in December (having since climbed to 2.8 per cent) was wholly incompatible with an economy that grew 3 per cent in the second half of last year and has more or less reached full employment. US corporate earnings, moreover, are expected to increase by a whopping 18 per cent this year, the strongest rise in profits since 2010, according to Credit Suisse.
An adjustment in stocks, particularly the frothy US market, was doubly overdue. According to one popular valuation measure, by early January US equities were even more expensive than on the eve of the Wall Street Crash in 1929. When asset prices enter bubble territory, a pullback is only a matter of time. This is what just happened in stock markets, with the S&P 500 still in positive territory this year and up nearly 20 per cent over the past year.
The Bad: It is troubling when markets interpret good news as bad news. One of the triggers for Monday’s sell-off was the publication last week of stronger-than-expected data on US wages, which grew nearly 3 per cent in January, stoking fears about a resurgence of inflation which could force the Federal Reserve, under its new chairman Jerome Powell, to tighten monetary policy more aggressively.
If investors and traders fear stronger growth, then markets are in an even more unhealthy state than was the case before the sell-off. From the standpoint of economic and corporate fundamentals, there is no compelling reason why equity markets should be suffering steep declines. At one point on Tuesday, European shares experienced their sharpest drop since June 2016, a day after the publication of data showing that the euro-zone economy is enjoying its fastest growth in 12 years.
Make no mistake, so concerned have markets become about an inflation-induced tightening in monetary policy that stronger growth is now perceived as a threat. This is preposterous.
The Ugly: The main culprit behind Monday’s rout in equities was the sudden and disorderly unravelling of the so-called “short volatility” trade. As I have argued in previous columns, the rapid build-up of bets on the continuation of low volatility in stock markets – Artemis Capital Management, a hedge fund, estimates these wagers amount to a staggering US$2 trillion – has significantly increased vulnerabilities in the financial system. While selling, or shorting, volatility was extremely profitable when the VIX Index, Wall Street’s “fear gauge” which measures anticipated volatility in the S&P 500, was at a record low, the trade has just backfired spectacularly.
On Tuesday, the VIX briefly surged above the 50 level for the first time since China’s shock devaluation of the yuan in August 2015, before easing back to 27. This was enough to pull the rug out from under parts of the so-called “volatility complex”. Not only were two popular investment products tied to the VIX forced to close, JPMorgan estimates that further spikes in volatility could trigger a further US$100bn in outflows from US equities.
The most frightening aspect of Monday’s sell-off is that it was caused mainly by two tiny VIX-linked securities at a time when the global economy is growing robustly and financial conditions remain exceptionally loose.
This begs the question: how much more severe is the unwinding of the short volatility trade likely to be when global financial and economic conditions worsen? Judging by Monday’s crash, far more severe.
While European stocks rose sharply on Wednesday, suggesting that the rally may have yet to run its course, volatility has finally erupted.
The market calm of 2017 is a thing of the past.
Nicholas Spiro is a partner at Lauressa Advisory