Prophets of market doom are jumping the gun
Last week’s turmoil suggests investors are belatedly coming to terms with the end of a decade of cheap money
At one point on Friday, the benchmark S&P 500 equity index was facing its steepest weekly loss since the dark days of the 2008 financial crisis. While stocks eventually found a floor, the index still suffered its sharpest five-day fall since the China-driven sell-off in January 2016. European equities, meanwhile, have just experienced their worst weekly decline since the acute phase of the euro zone crisis in 2011, while the Hang Seng Index dropped the most in a decade.
A staggering US$5 trillion has been wiped off the value of global equities since the turmoil erupted nearly a fortnight ago.
The VIX Index, Wall Street’s “fear gauge”, which measures the anticipated volatility in the S&P 500 and which gave rise to the complex financial products and trading strategies that are seen as the main culprit behind the sell-off, now stands just below 30, above its long-term average of 20 and sky-high compared with its subdued level of 12.7 at the start of this month.
Perhaps more worryingly, the sell-off in stocks is starting to put other asset classes under strain, notably corporate bonds and emerging markets, in a sign that last week’s dramatic price action might be a foretaste of things to come.
Yet the prophets of market doom are jumping the gun.
First, the about 9 per cent drop in the S&P 500 since January 26 leaves the index slightly out of correction territory – a drop of 10 per cent or more from a recent high – and still up more than 15 per cent over the past year. Moreover, the recent slump in the S&P 500 is on a par with the average largest yearly pullback in the index since 1980, according to data from Deutsche Bank.
The surprise is not that stocks have just suffered their sharpest fall in two years, but that markets had been extraordinarily calm for an unusually long period of time.
Second, and most tellingly for the time being, there has been no widespread panic. Assets that benefit during periods of extreme risk aversion, such as gold and the Swiss franc, even fell last week, while some riskier securities, such as the government bonds of Italy, rose in a sign that the broader market remains resilient.
This is because the sell-off is a technical one centred around the frothy US stock market as opposed to a broad reassessment of economic and corporate fundamentals, which remain strong. The abrupt unravelling of the so-called short volatility trade – highly leveraged bets on continued calm in markets – not only exacerbated the price declines but was the driving force behind it following the collapse of two volatility-linked financial products last Tuesday.
As for the initial catalysts for the surge in volatility – a sharp rise in government bond yields because of fears about inflation and concerns about a more aggressive tightening in monetary policy – some perspective is in order.
As I pointed out in an earlier column, while the 10-year treasury yield has shot up to about 3 per cent, real, or inflation-adjusted, yields are at a mere 0.7 per cent. This is still extremely low and a far cry from the about 3 per cent level at the end of the Federal Reserve’s last interest rate-hiking cycle in 2006.
Although US inflation expectations have risen over the past several months, the Fed’s preferred measure of inflation is comfortably below its target of 2 per cent while market expectations of inflation over the next 10 years are still only slightly above 2 per cent. In the euro zone, core inflation is just half the European Central Bank’s target.
Make no mistake, if there is a light that is flashing red, it is not inflation, which suggests that government bond yields are not about to go through the roof.
The most compelling explanation for last week’s turmoil is that international investors are belatedly coming to terms with the end of a decade-long period of cheap money. From an asset price perspective, last week marked the beginning of the end of the era of quantitative easing.
Bonds and equities – especially US assets – have been priced for perfection for far too long. It is about time that investors and traders began to reposition their portfolios for a new, and much more turbulent, financial landscape in which leading central banks are no longer propping up the financial system.
This does not mean that markets are about to enter a death spiral – far from it.
It simply means that the volatility of the post-quantitative easing era has begun. For markets that were in a near comatose state just a few months ago, this is no bad thing.
Nicholas Spiro is a partner at Lauressa Advisory