Posts tagged ‘volatility’
As years draw to a close it is customary for market observers to make early Christmas presents of their thematic predictions. Here are this blog’s thoughts on some major considerations for 2016.
Starting with the obvious: monetary policy will enter what has become very unfamiliar territory for some economies, including those of Britain and the US. Expectations are that the Fed will tighten policy by 25bp next week; as we have seen, the Bank of England is not expected to follow until well into next year. But market expectations are for the gentlest upward path for rates in recent history on both sides of the Atlantic. Anything more than this will come as a major surprise.
On a connected point, oil made much of the market and macro running this year. The key futures were making new sub-$40 lows just this afternoon. But the key point is that the average price over the last 12 months is $55 as against around $100 for 2014. For cheap energy to mimic the disinflationary pattern established this year would require oil futures to trade down to $30 and settle there throughout 2016. That is a real possibility. On the other hand, a change in OPEC / Saudi Arabian policy on supply could see the price start to climb again. Even if it manages to hold its 2015 range of about $40-60, that will still be significant as the “base effects” of cheap energy on inflation will fade away. In other words the oil price is set to remain a key metric for the world next year – and is entirely unpredictable.
Talking of unpredictable, the election of the next American President is already making headlines almost a year before the event. It will inevitably hog the political limelight in 2016. But elections and electoral arithmetic in Europe are much more interesting from an investment perspective. In several countries, “right-wing populist” or far right parties are riding high in the polls and they tend to be Eurosceptic. We will see how the National Front fares in French regional elections this weekend but there are national elections brewing elsewhere. In Holland, where an election must be held by March 2017 and if history is any guide will take place earlier, the Party for Freedom is polling in the high thirties. In the meantime the Dutch will be voting in an “advisory referendum” come April on the EU’s dealings with Ukraine. There is room for some mild upset on that front and transformational political change at the European level from Holland come the general election. During 2016 the British referendum on EU membership will also be drawing nearer.
Major equity markets showed degrees of volatility this year not witnessed since the crash and panic of 2011. Several currencies had a turbulent time of things too. With the other themes in mind it appears likely that volatility will again feature in 2016.
This list is not exhaustive but will provide us with plenty to chew on over the coming months. In the immortal words of Louis Pasteur: chance favours the prepared mind!
In these uncertain times, let us refresh ourselves by beginning with what was again proved this week to be an indisputable fact: Mario Draghi is the most significant and successful central banker in the world.
The announcement three years ago that the ECB was assuming the power to intervene in bond markets, when he was not even 12 months into the job, put the sovereign debt crisis to bed, restored market confidence across the world and helped turn the creaking hull of the eurozone supertanker away from recession. Two years later his €400bn bank liquidity programme and adoption of a negative policy rate had analysts calling him a rock star. Another €700bn splurge and surprise rate cut followed. And at the beginning of this year Mr Draghi announced a €1.1trn programme of quantitative easing.
So yesterday’s announcement that the ECB was ready to modify the “size, composition and duration” of its QE exercise was part of a pattern. Draghi and team are being seen to do whatever it takes to re-normalise the eurozone economy. Indeed, as he put it at a speech he gave in London on 26 July 2012:
The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
Everybody believes you now, Mr Draghi.
Market reaction yesterday and overnight was, in a word, electric. The euro plunged by 1% against the dollar in the space of half an hour to close the day 2% weaker overall. (That is a more significant one day fall than the planned devaluation of the Chinese yuan that caused such consternation back in August.) The Euro Stoxx 50, which had been trading flat throughout the morning, rocketed up in the afternoon to post a +2.5% close. European bond yields hit new record lows: the 2-year bund was pricing at -0.35% in the opening hours of this morning while the 2-year Italian buono hit negative yield territory for the first time.
There is a good, detailed overview of the global impact of Mr Draghi’s latest star performance from Reuters here: Global Stocks Hit Two-Month High On Dovish Dragi Message. But it is the quotes from market observers which we will focus on before leaving this subject:
“Investors and traders are buying the idea of expected action out of the Bank of Japan and the ECB,” said Ben Le Brun, market analyst at trading platform provider optionsXpress.
The Chinese central bank’s injection of 105.5 billion yuan into 11 banks via its medium-term lending facility this week, combined with possible additional stimulus from the ECB, “may give the Fed more reason to raise rates by year end,” said Chris Brankin, chief executive officer of online trading platform TR Ameritrade Asia in Singapore.
“Draghi has come out and kitchen-sinked the whole thing, everything is now on the table,” said Gavin Friend, a strategist at National Australia Bank in London. “You combine what the ECB is now saying with (the fact) that the Fed is not going to be going aggressively and that the Bank of Japan is going to want to get involved, then you say ‘Blimey!'”
Mr Draghi has played his role exceptionally well, but the dominance of central bank rhetoric and activity over market behaviour is unhealthy. When the People’s Bank of China devalued over the summer for example it was treated as a disaster – a desperate act to prop up a seriously weak economy. The falling stock market in China had helped unsettle the world and the markets’ interpretation of events took place against a background of gloom. This week, however – thanks to the ECB – we inhabit an era of sunshine and optimism. So when the PBOC announced further monetary loosening today it was seen not as desperate but as a sign of “the government’s determination” which has now lit “a fire under global stocks” as “US equity futures jump”, to quote some of this afternoon’s commentary. Markets hated Chinese policy over the summer and loosening by the PBOC was taken badly; today it’s just what was needed to cement the rally in place.
If there is a cloud to go with this week’s silver lining, therefore, it is the now familiar truth that reliance on central banks has become a major source of volatility. “Money Markets Primed for Draghi as Bets Jump on Deposit-Rate Cut”, says Bloomberg’s headline today. And what if there is no cut on 3 December? Or if there is, but this is seen as bowing to market pressure – the kind of pressure which appears now to govern decision-making at the Fed? One day markets are given a boost by “Super Mario”, the next, they start looking for more – and pricing it in.
Volatility is the textbook definition of financial market risk. Mario Draghi is, to say the least, an impressive figure. He has given investors much to be very grateful for. But he and his confreres around the world, counter-intuitive though it might seem, have actually helped to make investing today a riskier proposition. To put it another way, we have become used to looking to central banks to underpin market stability; and by relying on them to the extent that we now do, ensured the exact opposite.
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.
As this week showed, markets remain jittery. The FTSE 100 had edged up to a new high of 6878 on Wednesday, only a handful points short of its all-time closing peak of 6930 in 1999, only to give up its gains yesterday in the biggest daily fall for a month. At the same time, the ten year gilt yield – which had been stuck in a range of between 2.6% and 2.8% for three months – broke lower in the biggest one day fall since January to reach its lowest point since last July. And continued euro weakness saw the pound reach a new high of 0.814 (or 1.23 for those of us who prefer our sterling exchange rates the right way round), its strongest level against the euro since January 2013.
In fact, listen to some fund managers and 2014 has been a shocker. Technology shares, which were supposed to keep going up, have underperformed, with the NASDAQ down in absolute terms and 4% behind the S&P 500 for the year to date. Indeed, some of the big internet names in particular have taken a major bath: Amazon is down 26% and LinkedIn down 33%. Last year’s massive bull trend in Japan is nowhere to be seen with the Nikkei 225 down 13%, comfortably the worst performer of any major market. Emerging markets have been outperforming (by 5% over the last three months). Duncan’s horses have turned wild in nature and gone for a picnic. For many participants it has been a bruising time.
And yet in truth, things have not been as exciting as it has sometimes felt. Equity market volatility has not been anything like as high as it was when the taper tantrum kicked off just under a year ago. Indeed, some swift linear regression to the FTSE 100 over the last 12 months shows that its line of best fit has risen 4.5% in price terms over the period. Coupled with a dividend yield of about 4% and CPI inflation of an average 2.3% over the same period and you’re looking at a real return of 6.2%, which is so near to the textbook number for expected long run returns to equity as makes no difference. Putting it another way: the equity market, despite patches of volatility and some sector fireworks, has in aggregate been quite boring – and that was always the consensus view for the major markets going in to 2014.
The economic data has been unspectacular too. Eurozone GDP for Q1 out yesterday was a little weaker than expected, but there was nothing to derail the expectation of dull and sluggish – but positive – growth this year. Employment data has continued to show measured strengthening at home and in the US, while in both countries, activity indicators have stayed healthy though below recent peaks. There have been no signs of further deterioration in EM, nor any evidence of anything beyond a gradual uptick where numbers have been positive. On the political front the Ukrainian situation remains worrying, but there has not yet been anything to match the annexation of the Crimea and there have been no more big surprises elsewhere.
In fact wherever you look – eurozone bond markets, precious metals, credit spreads, oil and gas – there have been occasional episodes of excitement, but nowhere near enough to keep the casual viewer watching. It has been a dull old time. (Unsurprisingly this will have benefited dull old portfolios. Income investors, both within equity markets and as holders of bonds, will have done pretty well.)
So these jittery markets have not really been as dangerous as they seem. But since nothing lasts forever, the question is: how worried should we be about what comes after the boredom? Will “risk on” be unharnessed as recovery continues? Or will there be another shock, or disappointment, which will make the last few months seem like the calm before the storm?
Perhaps the most sensible approach for investors to take in these circumstances is to resist the temptation to actually do very much. There has been little change in fundamental data to challenge whatever positions they may be taking, and in many markets, rarely enough volatility to suit those waiting either for a buying opportunity or to take profits. Best to stick to one’s views, save some trading costs, and see what happens next …
“As a bear case it is a tempting proposition. Just when we have all started ignoring Europe, a new bailout or political upset will come along and upset the apple cart again.”
So this blog speculated all of seven days ago. Since when, two shock ministerial resignations in Portugal threatened to bear the point out directly.
Markets appear to be considerably less fragile than they were a couple of years ago, but this is still the kind of surprise they can do without. On Wednesday the Portuguese stock index fell by more than 5% and the country’s ten year bond yield rose from 6.5% to an intraday high of almost 8%. It looked as though the European drama was about to begin yet another deadly act.
Perhaps it was fortunate that attention was distracted by revolution in Egypt that very day. This was received more favourably by local markets, with the Egyptian Exchange index 7% higher on yesterday’s close. And as of this afternoon, negotiations in Portugal seem to have headed the crisis there off: bond yields have settled below 7% again and the equity market has recovered about half its lost ground so far. (German finance minister Wolfgang Schäuble did make one ominous comment though: “I think the euro is now viewed on the world’s financial markets as so stable that domestic political situations in individual countries … don’t mean a crisis for the stability of the euro as a whole.” So we can’t be out of those woods yet.)
If nothing else, the relatively sanguine response to these events tells us something about market confidence. The absorption of Portugal’s left-field political turmoil in particular is worthy of note. Above all, however, they remind us that we cannot plan for tail risk, and we certainly cannot be sure exactly what the view round the next corner is going to look like once we get there.
Lacking omniscience, we have a clear choice. We can allow ourselves to be spun into a dizzy panic by day-to-day news flow and volatility. Or we can follow the fundamentals, watch what happens to pricing – and try not to get so thunderstruck we lose the conviction to exercise our judgement accordingly.
As readers know, markets enjoyed a period of relative stability across the summer of 2012. Despite the mild nerves shown over the last week or two, that stability has largely continued. But one of the events which has emerged to threaten it of late should serve as a reminder that this should not make us complacent.
Barcelona has voted for independence from Spain. A short year ago this would have seemed unthinkable – not to mention rather ridiculous. It is a classic “black swan” event. Everyone has been worrying about the breakup of the eurozone; no one has worried about the breakup of a European country since the dissolution of Yugoslavia. And as for the breakup of Spain in particular, who would ever have thought of betting on the Catalans over the Basques?
Of course, local politics is still politics. The region of Catalonia has been begging for a central government loan for some time. (It is surely a tribute to humanity’s persistency of spirit that so many of us believe in borrowing our way out of a debt crisis.) Perhaps their threatened secession is no more than a bargaining chip.
From the market reaction so far the threat does not seem too powerful, but it is instructive. This year might have been quiet – so far – but remember what happened in 2011: the Arab spring, the Japanese earthquake and tsunami, the referendum gambit in Greece and subsequent fall of the government … All these things were unpredicted and unforeseen.
Over the next few months, who is to say what might not happen? We wait anxiously for military action against Iran while there is civil war in Syria. Anti-Japanese sentiment in China has had real social and commercial effects. Then there is the enigma of North Korea. The dominant military power in the Pacific is the United States. Could it be possible that, one day, America will have to learn the lesson it taught Britain over Suez: that an indebted nation can only fight with the permission of its creditors?
It doesn’t pay to be too terrified, however. There is more to markets, and economics, than political events and natural disasters. A year after Suez, and Harold Macmillan was telling people they had never had it so good; according to the Barclays Equity Gilt Study, British stocks during the period 1956-1960 delivered a compound annual return of over 13% in real terms.
As we have all been reminded in recent times, volatility can be painful. But left field events cannot be planned for. Difficult as it can sometimes seem, the safest option is to back the fundamentals.