Are investors too complacent or are commentators too bearish?
While finance journalists are focusing on economic risks, key gauges of sentiment suggest international investors are unconcerned
At the beginning of last week, financial markets were on edge.
Fears that the US Federal Reserve may announce an acceleration in the pace of monetary tightening at its interest rate-setting meeting on Wednesday and that Geert Wilders’ far-right party would perform well in a parliamentary election in the Netherlands the same day made for a nervous start to the trading week.
Yet the anxiety quickly dissipated following the Fed’s decision not to quicken the pace of rate rises and a worse-than-expected performance by the far right in the Dutch elections.
The yield on benchmark 10-year US Treasury bonds immediately fell 10 basis points after the Fed’s decision, to just under 2.5 per cent, and is now back below its level in mid-December. On Thursday, the Euro Stoxx 50 Volatility Index, Europe’s so-called “fear gauge” which measures investor expectations of large swings in European equities, dropped to its lowest level since before the 2008 financial crisis.
This is just a snapshot of the dichotomy that pervades global markets: while much of the commentary in the financial media – and a significant portion of the analysis from investment banks – focuses on risks and vulnerabilities in the global economy, key gauges of sentiment suggest that international investors are unconcerned, and indeed positively bullish in many segments of the market.
There is a conspicuous disconnect between the headlines and price action in markets – so much so that it often feels like the financial news and analysis business and the investment community are existing in parallel worlds.
This is partly due to the fact that financial journalists and analysts are, as John Authers, the investment commentator of the Financial Times, rightly notes, subject to a strong bias in favour of negativity. “Why would a forecaster want to avoid missing a serious negative moment? Nobody wants to be remembered this way. Expect forecasters to continue to err on the side of caution,” Authers wrote in the FT earlier this month.
The dichotomy also stems from – and is perpetuated by – the remarkable resilience of markets over the past several years, particularly since the European Central Bank (ECB) averted a break-up of the euro zone in July 2012 by pledging to backstop the bond markets of Spain and Italy, thereby restoring investor confidence in Europe’s fragile single currency area.
Even though the Fed is raising interest rates, global financial conditions remain extremely accommodative, with the ECB and the Bank of Japan still engaged in aggressive quantitative easing.
These ultra-loose monetary conditions – the global stock of negative-yielding bonds still stands above US$10 trillion, according to Tradeweb, a bond trading platform – continue to distort asset prices, maintaining a dangerous wedge between investor sentiment and underlying fundamentals. While the Fed hiked rates by a further 25 basis points last week, financial conditions actually eased because of the less hawkish than expected outlook for US monetary policy. This delivered an effective rate cut of nearly 15 basis points, according to Goldman Sachs.
Thirdly, and just as importantly, the naysayers were proved wrong about the adverse impact of the Brexit vote and Donald Trump’s shock victory in the US presidential election on market sentiment.
UK stocks are up 17 per cent since the Brexit vote (buoyed by the sharp fall in the pound) while the yield on 10-year UK government bonds is 10 basis points lower. In the US, meanwhile, equity markets are hovering near record highs, with the Vix Index, Wall Street’s own “fear gauge”, standing close to a historic low.
This begs the question: are commentators and analysts too bearish or are investors overly complacent?
The honest answer is a bit of both.
Financial journalists and investment strategists underestimated the resilience of markets to last year’s political shocks and, quite possibly, are making too much of the chances of far-right leader Marine Le Pen winning the decisive round of France’s presidential election on May 7.
On the other hand, popular gauges of market sentiment, such as the Vix Index, may not be accurately reflecting levels of investor anxiety.
The Skew index, compiled by the CBOE, the world’s largest options exchange, which measures the difference between the cost of buying protection against a sharp decline in equities and the cost of buying the right to participate in a rally, has surged to its highest level since the Brexit vote.
In other words, scratch beneath the surface of positive sentiment and it becomes apparent that investors are not as insouciant as it appears.
Commentators may be overly bearish, but many investors are concerned that market conditions may have become too buoyant.
Nicholas Spiro is a partner at Lauressa Advisory