No time for nonchalance, no matter the markets’ ongoing resilience
The recent escalation in global trade protectionism, when the global growth spurt appears to have peaked, could still put markets under further strain
When a bout of turbulence swept through financial markets at the beginning of last month, wiping US$6 trillion off the value of global equities, many investment strategists and commentators, including some who write for this paper, predicted markets had “reached a tipping point” and were bound to suffer a prolonged and disorderly correction.
At the time, I argued that talk of a financial meltdown was wide of the mark and that there was little indication that the ructions in US stock markets were undermining sentiment towards other asset classes, or that the sell-off was forcing international investors to fundamentally reassess their sanguine views of the global economy and corporate earnings.
Yet the sharpness of the rebound has been striking.
Not only did markets snap back almost as quickly as they tumbled, the VIX Index, Wall Street’s so-called “fear gauge” which gave rise to the speculative bets on subdued volatility which backfired last month, is back below its long-term average level of 20 having briefly hit 50 on February 6.
While equities were under renewed strain on Wednesday following the decision by Gary Cohn, US president Donald Trump’s top economic adviser and Wall Street’s representative in the White House, to resign because of his opposition to Trump’s plan to impose tariffs on aluminium and steel imports, markets have quickly brushed off the recent spike in volatility.
The facts speak for themselves.
The benchmark S&P 500 equity index is up nearly 6 per cent over the past month and is even higher than when Trump announced the tariffs last Thursday.
Despite the sharp fall in equity prices in early February, the S&P 500 is still 2 per cent higher than at the beginning of this year. More tellingly, Wall Street stock analysts remain bullish.
According to DataTrek Research, a US market consultancy, analysts have raised their 2018 whole-year estimates for corporate earnings growth from the S&P 500 to 18.3 per cent year-on-year, compared with 16.8 per cent just before February’s sell-off.
Even more conspicuous examples of market calm can be seen in the muted reaction to the victory of populists and nationalists in last weekend’s Italian parliamentary election, and the resilience of the US$1.3 trillion high-yield, or “junk” bond market, which is a key bellwether for investors’ appetite for risk.
The strong showing of Eurosceptic parties in Italy’s election – the anti-establishment Five Star Movement and the anti-immigrant Northern League party won a combined half of the vote – caused barely a ripple in Italian and euro zone debt markets, contrary to the warnings of many commentators.
The spread, or gap, between the yield on Italian 10-year bonds and its German equivalent has barely budged since the election, while Italy’s yields have even fallen over the past three weeks.
More tellingly the prices of junk bonds, which usually decline if equity markets come under severe strain, remain at elevated levels despite the recent surge in volatility.
According to data from Bloomberg, the bonds of the riskiest US companies have even outperformed those of their higher-rated counterparts this year in a sign that the hunt for yield shows no signs of abating.
Make no mistake, investors shrugged off February’s mini-crash in a matter of days.
Yet while the resilience of markets was clearly underestimated by many commentators, the complacency that contributed to the sell-off has been shown to be even more pervasive than previously thought.
While much of the decline in equity prices in early February was concentrated in the US, and in a much-publicised corner of the market known as the “volatility complex”, the bout of turbulence raised questions about stretched valuations in markets, the end of the era of cheap money and the mispricing of risk.
The volatility genie was let out of the bottle and investors were given a foretaste of what could be in store for markets once central banks withdraw stimulus more aggressively.
That investors remain insensitive to major risks and vulnerabilities in the financial system is troubling and shows that things need to get a lot uglier in markets for sentiment to turn.
The recent escalation in global trade protectionism, coming at a time when the global growth spurt appears to have peaked, could put markets under further strain.
Yet the most likely catalyst for a more severe and prolonged sell-off is the end of quantitative easing, which is still some way off.
Last month’s mini-crash revealed that the rally has yet to run its course. Ditto market complacency. Just because a meltdown was averted does not mean investors should be insouciant – indeed quite the opposite.