Surprisingly strong US dollar and return of volatility shatter investors’ once-bullish confidence
Nicholas Spiro says investors started the year assured of stability, global growth and a weakening dollar, only to see all three expectations unravel which, along with new doubts about the euro and talk of trade war, have seriously shaken confidence
As the second half of 2018 gets under way, financial market bulls can be forgiven for asking themselves how it all went so wrong.
At the start of this year, most investors were convinced that volatility would remain subdued, the period of synchronised global growth would persist and the US dollar would continue to weaken.
In the January edition of Bank of America Merrill Lynch’s authoritative global fund manager survey, a monthly report which canvasses the views of institutional investors around the world, “shorting”, or selling, volatility was the most popular trade.
Fast forward five months, and all three of these big bets – as well as several others, such as bullish wagers on the stock markets of the euro zone – have backfired spectacularly.
In a sign of the extent to which market developments have wrong-footed investors, the previously paltry returns offered by cash have beaten those on bonds and equities. According to a report from JPMorgan summing up the first half of this year, “returns this low and this broad have only occurred twice in the past 25 years”.
What has caused the major asset classes to perform so poorly?
While there are a number of factors at play, the most important one has been the unexpected return of volatility.
Rather than assessing how markets fared over the course of the past six months, the first half of this year needs to be divided into two parts: the stellar returns in January and the dramatic change in market conditions that occurred in early February when a sudden outbreak of turbulence wiped more than US$5 trillion off the value of global stocks in less than a fortnight.
A 7.5 per cent rise in the benchmark S&P 500 between January 2 and 26 was followed by a more than 10 per cent plunge in the ensuing 10 trading sessions.
The eruption of volatility was a game-changer for markets, turning a financial landscape which for more than a year had been characterised by long periods of calm, high returns and excessive complacency into one exhibiting sharp swings, low returns and increasing nervousness.
According to Bloomberg, in the first half of this year, the S&P 500 experienced 36 one-day swings of at least 1 per cent, four times the total for the whole of 2017.
This new regime of higher volatility, although much more in line with historical trends, has shaken market confidence, forcing investors to rethink their core assumptions about growth and the performance of asset classes.
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That the re-emergence of volatility took place just when the Federal Reserve, under its new chairman, Jerome Powell, turned more hawkish – and when tensions over global trade escalated sharply – has cast further doubt on the market narratives that were popular at the start of this year.
The trade that has unravelled most dramatically, and which has had the greatest impact on markets this year, is the “short dollar” wager. As recently as April, bets on a further decline in the US dollar were one of the most crowded trades, according to the April edition of BAML’s fund manager survey.
Yet, following the dollar’s best quarterly performance since the end of 2016, investors are now speculating that the rally will continue, with “long dollar” positions ranking as one of the most popular trades in BAML’s June survey.
The dollar’s revival has been the key factor behind the recent tightening in financial conditions which has put emerging markets under significant strain.
Bullish forecasts for developing economies in the first quarter of this year are no longer the consensus among investors.
In a sign of the extent to which sentiment towards emerging markets has turned, China, whose equity markets have entered bear market territory and whose currency suffered its largest ever monthly decline against the dollar last month, has become a focal point of market anxiety for the first time since the fallout from the unexpected devaluation of the yuan three years ago.
A resumption of China-induced fears are adding to concerns about global growth – the foundation for bullish forecasts at the start of this year.
While investors were fairly relaxed about the Fed’s plans for monetary tightening under Powell’s predecessor, bond markets are now signalling a risk of excessive tightening that could cause growth to slow, forcing the Fed to pause, if not cut interest rates.
All these concerns – China, the Fed and the health of the global economy – may yet prove to be overdone. Yet with volatility having returned with a vengeance, fear begets more fear, as January’s market bulls now know only too well.
Nicholas Spiro is a partner at Lauressa Advisory