Risks posed by trade war and Federal Reserve policy are graver than investors seem to realise

Markets must come to terms with the fact that China and the US are too far apart on crucial issues for the trade war to be resolved soon
When central banks themselves have become sources of volatility, investors must wake up to the dangers of underpricing risk

Nicholas Spiro

Published: 1:00pm, 20 Jun 2019

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Have financial markets become too complacent? At first glance, it is difficult to argue that investors are not paying enough attention to the two most important issues facing markets: the US-China trade war and the conduct of American monetary policy.

At the end of last year, US stock markets suffered their worst December since 1931 due to fears that the Federal Reserve was underestimating the deterioration in global growth and was hell-bent on tightening policy further. When the Fed began signalling in early January that it was prepared to change course by putting its interest-rate-increase campaign on hold, markets roared back, with the yield on benchmark 10-year Treasury bonds falling nearly 80 basis points since mid-January to just over 2 per cent.

Investors also took fright at the severe escalation of the trade war early last month, when US President Donald Trump moved to restrict the access of Huawei Technologies to America’s market and suppliers, shifting the focus of the conflict to the all-important technology sector. The New York Stock Exchange’s FANG+ index, which tracks a basket of global tech companies, is down 10.6 per cent since May 3.

Yet, closely watched measures of financial volatility remain remarkably subdued, and have even fallen since Trump revived his trade offensive against China. The VIX Index, Wall Street’s so-called fear gauge which measures the implied volatility of the S&P 500 equity index based on options prices, is down 30 per cent since May 13, and as much as 60 per cent since the height of the sell-off last December. Indeed, the S&P 500 itself currently stands a mere 0.6 per cent below its all-time high set on May 3.

A report published by JPMorgan last Friday, which looked at a dozen gauges of volatility across five separate asset classes, noted that “option markets do not embed enough cushion against the significant event risk markets are facing over the coming weeks”. How much extra cushion there should be is debatable. What is clear is that investors are significantly underpricing the risks surrounding the Fed and the trade war.

It is shocking that only six months after the Fed was intending to raise rates two times in 2019, bond markets are now pricing in at least two cuts by the end of this year, and assigning a 100 per cent probability to a reduction next month.

As I have argued previously, America’s economy, while having slowed markedly this year, is hardly on the verge of a recession. The US consumer remains in fine fettle, a boon given that personal consumption accounts for 70 per cent of economic output. Retail sales grew for the third straight month last month.

By goading the Fed to cut rates sharply, investors risk shooting themselves in the foot. If America’s central bank were to begin loosening policy in the face of what is still a relatively strong economy, there is a significant risk that markets end up treating the move not as a pre-emptive cut, aimed at averting a sharper slowdown, but as a clear indication that the economy is in trouble. Rather than dispelling fears of a recession, the Fed could end up heightening them.

America’s central bank is acutely aware of these risks. At its rate-setting meeting on Wednesday, the Fed released new forecasts which showed that borrowing costs are likely to remain unchanged for the remainder of this year, with only one cut expected next year. The Fed is not planning to slash rates aggressively, at least not yet.

US Federal Reserve chairman Jerome Powell speaks at a press conference in Washington on June 19. The Fed left interest rates unchanged after officials weighed mixed signals on the health of the US economy and the impact of trade tensions. Photo: Xinhua

Investors should also reassess their assumptions regarding the risks surrounding the trade war. How much more proof do markets need that Washington and Beijing are too far apart on the key issues bedevilling US-China relations – in particular the verification and enforcement mechanisms demanded by the White House to ensure that China changes its industrial and technological development policies – to reach any meaningful and sustainable agreement?

When sentiment is being swayed almost entirely by Trump’s impulsive and facile tweets, one must wonder whether investors have taken leave of their senses.

The bigger concern, however, is that the entire financial system is broken following a decade of ultra-loose monetary policy that has distorted asset prices to such an extent that markets are no longer capable of pricing risks correctly.

The frequent surges in volatility last year, although terrifying for investors who had grown accustomed to tranquil markets, were a reminder of the dangers of underpricing risks when central banks themselves have become sources of volatility.

When sentiment is being swayed almost entirely by Trump’s impulsive and facile tweets, one must wonder whether investors have taken leave of their senses

In its latest fund manager survey published on Tuesday, Bank of America Merrill Lynch found that investors have never been this bearish since the global financial crisis. Yet the FTSE All-World Index, a gauge of global stocks, is currently less than 5 per cent shy of its record high set in January 2018.

This is not a sign of complacency. Rather, it is an indication that investors can no longer assess and price risks properly.

Nicholas Spiro is a partner at Lauressa Advisory

This article appeared in the South China Morning Post print edition as: Why markets can no longer assess and price risks properly

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