A Period Of Turbulence

17/10/2014 at 5:26 pm

What an interesting start we have had to the final quarter of 2014. The FTSE 100 index has skittered down to a 15-month low; the ten year German bund yield has plumbed record depths; crude oil has broken back down to 2010 prices; Greek bond yields peaked at over 9% today, up from 6.5% at the start of the week. A lot of people are worried, which is understandable. The key question is: do we understand why this has happened?

Whatever the true level of our understanding of the causes of recent volatility, we have not been short of explanations. There have been mutterings about growth from both the OECD and IMF in recent weeks. Fears persist over European deflation. Ebola remains uncontained in West Africa and has spread to more countries outside that region. The Islamic State has threatened to take a town on the Turkish border. Negotiations between Russia and the West over Ukraine remain tense and at a seeming stalemate. And what of China? And interest rates? And tapering?

Try to relate these concerns to market behaviour, however, and one hits something of a brick wall. We knew that the US contraction in Q1 and the eurozone slowdown in Q2 were worse than expected months ago. Japan’s policy-driven deceleration was widely expected, and planned for, well in advance. None of the changes to OECD and IMF forecasts reflect any new data seen over recent weeks. Connecting the very familiar global growth picture to the rather sharp repricing we have seen looks otiose.

Indeed, only yesterday, eurozone data showed annual inflation stable at a low 0.3%, while the index went up by 0.4% in September – the biggest monthly gain since March – after an 0.1% rise in August. Core inflation actually came in at an annual 0.8%, a touch higher than expected. And even if we grant bond markets perfect foresight, and believe that they are efficiently discounting the near-future reality of deflation in Europe, what did the ten year bund think it was doing at 0.7%? In the 2000s, when Japan actually went through protracted deflation, its ten year paper averaged 1.5% and closed above 1% for over 90% of that decade.

Then there is oil. Increased turmoil in the Middle East is not generally associated with soft oil prices – never mind spikes down. Now oil had a terrible third quarter this year, and at least some of this can be attributed to the strength of the dollar over the period. But the dollar is weaker this month, and the Brent crude future down by 9%.

Let’s look at the increase in concern over the spread of the Ebola virus. Ebola – a terrifying disease with a high mortality rate and no reliable cure – was first diagnosed in the USA on 30 September. The S&P 500 is 4% lower now than it was then. Perhaps it is fears over the illness which are to blame for market nerves. So why in London, where Ebola has yet to be found, has the market wound up falling 5%? And the Euro Stoxx 50 has fallen by 8%. In fact, though there is only a hair’s breadth in it, the main stock index in Spain – where the virus recently broke containment – has outperformed.

Some have been joining the dots between oil, growth, and emerging markets. China, of course, is always good for a scare story. And yet the Shanghai Composite has hardly budged and the yuan has continued its sluggish appreciation against the dollar. Even in Brazil, where growth concerns have been more readily supportable for some time, the stock market is up – by 3% at the time of writing. The real is unchanged against the dollar so far this month. Russia has seen some muted weakness (equity down 1.9%, rouble off 2.6%), and at least there is a clear causal link here between the oil price and one of the world’s most significant energy exporters. But as should be pretty clear by now, a lot of the explanation which has been offered for market behaviour lately has been specious.

What we have been seeing, then, is an uneven, unexplained and – if we are honest – not terribly remarkable funk. Between 7 July and 10 August 2011 the FTSE 100 fell by more than 17%. Now that’s volatility. The VIX index of volatility in the US was almost twice as high in those days as it is today.

Most importantly, the world economy was in a very different place back then. For much of the autumn of that year there was the very real chance that the bond market would bankrupt Italy. Should that have happened it would probably have crashed the global banking system and ushered in chaos across the world. Sentiment was universally weak: even in the US there was still talk of a “jobless recovery”.

Times have changed – thankfully – and the fundamentals have improved. Nor have they shown the slightest sign of measurable deterioration since mid-September! Tail risk is always with us, but specific black swan events represent perfectly unknowable outcomes. Portfolios cannot be built on that basis.

Sensible practitioners realise this and there has been some cautious sanity quietly issuing from bank research rooms over the last few days. It is never pleasant to have one’s flight jolted by turbulence for a prolonged period. We have, however, seen much worse than this in recent years – with good reason, too. This is not to say that the storm won’t worsen; of course it may. The only rational thing we can do is to weather it.

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